ONE VIEW I READ IN AN ARTICLE some time back stop-loss orders are not used to protect an open-trade profit. They are not a risk control tool. Stop-loss orders are profit management tools and should not be used to liquidate winning trades. They should be used to liquidate a position—any position—when something has changed with the underlying structure of the market, and not before. If you follow this thinking to its logical conclusion, that your winning trade is happening only because you are on the right side of the net order flow at that moment, then the best time to liquidate that winning trade will be only at the point when the net order flow in that direction is about over. In other words, you have bought low and sold high for the maximum potential before the net order flow reverses. If you have called it right then the fact is that your protective stop-loss order was never in question—the market had no potential in the direction against you, and you were properly positioned for that order flow. Therefore, the stop was not elected. In fact, you could almost go so far as to say that if the stop order was never placed, the result would have been exactly the same because the
Why then would you move your stop?
I think that is the critical issue of properly using stop-loss orders. If you have properly identified the net order flow, the stop is not needed and might as well not be there. All the little price ticks in all those tiny little switchbacks or corrections are not the issue; the issue is whether the net order flow has changed. You would only move your stop-loss order if you
are not certain that you have identified where the order flow has run out of potential. You place your original stop-loss order only to protect yourself in the event that you have not properly identified the initial place where the order flow will change; if you are incorrect in your entry, you have limited your loss to a predetermined amount according to your system
methodology and trade plan. If you are correct in your assessment, then there is nothing to do but wait until the net order flow runs out of potential in that direction. If you are uncertain of that point, then the movement of the stop closer to the traded prices is your only option. And that brings us to the point of subsequent stop-loss order placement
after the market has begun to show you an open-trade profit. It is the psychology of moving this stop-loss order that is the central issue of properly using stops, because they are notneeded if your first hypothesis is the correct one, unless something has changed and you missed it.
If you intend to use stop-loss orders effectively, you need to use them as a worst-case exit order only. Your first worst-case scenario is being in the market on the wrong side of the order flow at the moment of initial entry.
The next-worst case is that the order flow runs out before you have a reasonable lead on the market. The third-worst case is if something changes and you didn't see it coming fast enough to liquidate with what the trade had in it at that point. Otherwise, the only thing to do is wait for your objective.
In my view, rolling stops aggressively to lock in profits is the surest way to cut profits short. Regular ebb and flow in the small order imbalance, regular retracements from significant highs or lows, and random noise between highs and lows are part of the game. It is unlikely that you or any trader will be keen enough on your observation that you will accurately call the near-term price points for such price action. Placing your stops too close to the market is an expression of uncertainty and fear, of attachment to a particular price instead of waiting patiently for the net order flow to run out in that direction. By rolling your stops aggressively you run the risk of having your stops elected by the minor tick-by-tick order imbalance. To avoid this potential, you need to see stops as the method of liquidating only if something has changed. If nothing has changed with the structure of the market, why would you increase your risk by moving a stop-loss order?
One way to make the issue of placing stop-loss orders work for your particular trade approach is to move the stops for only two reasons. The first reason is to take you out at a predetermined dollar loss or gain amount as defined by your risk management rules. In other words, if the trade is working up to a certain amount of open-trade profit, you move
your order to secure either a smaller loss/break-even amount or a small profit. After that point, the stop should not be moved until your objective is reached.
The second reason to move a stop would be if you are pyramiding open trade positions. It would be advisable to
always have a break-even exit stop on your entire position in case something changes and the pyramid begins working against you, and the open trade position falls below your starting equity on the trade.
In all other cases, moving your stops aggressively is a dangerous and unnecessary method of increasing your risk of cutting a profit short. Once a trade has given you a reasonable lead, you can make the near-term assessment that your hypothesis is the correct one. And once that trade is protected for little or no risk, moving a stop-loss order closer to the market on a regular basis will only put you in the position of getting caught in the random minor tick-by-tick action that you have no need to be concerned with anyway. If something has changed, and you don't see it fast enough to keep most of the open-trade profit from evaporating, why would you want to be in a market that you don't see right in the first place?
Always remember that stops are not risk management tools. They are profit management tools. They can only be considered risk management tools if something has changed and you are on the wrong side of the order flow by accident; in which case you would act in your best interest by liquidating anyway—except it happened faster than you could see at your
current skill level.
In any case, your equity is protected and you can now look for the next trade with a clear head. Judgment day is every day, so place stops properly.
To: Technical-Investor@
From: rk1235_mb@hotmail.
Date: Tue, 17 Nov 2009 07:58:30 +0530
Subject: Re: [Technical-Investor
----- Original Message -----From: JayakrishnanSent: Monday, November 16, 2009 9:44 PMSubject: [Technical-Investor] Stop Loss: Protecting your Profits.
STOP LOSS
A quote from Don Worden, founder of Telechart 2000 and chartist extraordinaire.
"This one is so simple and obvious I'm almost ashamed to reveal it. It can and probably should used as a supplement to all other exit strategies and all combinations of exit strategies. After you are once 10 percent ahead, don't ever give back more than 66 percent of your profit. After you are once 20 percent ahead don't give back more than half your profit. After you are 50 percent ahead, don't give back more than a third of your profit."
1. Let's dissect Worden's suggestion for understanding. Consider the following table which lists three positions in a stock whose initial purchase price was $50.00 per share. Each of the three scenarios mentioned by Worden are included; ahead by 10%, 20% and 50%. The stop loss for each case is shown in the next to last column. These values would provide the profit protection prescribed.
2. I find it difficult to deal with the many conditions we might encounter. Such as, where do we set the stop if we are 15% ahead? Or 28%, etc., etc. To help simplify, I've included in the last column of the table what percent of the current price the stop represents. Interestingly, these percentages are not too different. In fact, if we set our profit-protection stop at 94% of the current price no matter how much our profit, the following results.
3. The comparison to the previous stops show the differences become greater the further our profit has increased. The danger here is in getting the stop too close to the current price. One way out of this dilemma is to use the 94% stop until we hit 20% profit, then revert to a flat 90% stop. The following results.
4. The differences are now manageable and this provides us with a simple guideline to follow:
a. If the prices increases putting us 10% ahead, set a profit-protection stop at 94% of current price.
b. When the price increases putting us 20% ahead, set the profit-protection stop at 90% of the current price.
From the net........
Regards,
Jayakrishnan.
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