Stop losses are wonderful things – they protect our funds, they let us get to sleep at night, and I wouldn’t trade without them.
Yet …
Stops are one of the most enduring frustrations of trading. One of the most frequent complaints I hear from traders is about getting “stopped out, only for the price to turn around” …
It happens to us all – and has to be accepted as a natural “downside” to the benefits we get from our stop-loss insurance.
However, if it’s happening too often, then something is amiss …
How to make sure that stop losses don’t stop you out
Today I’d like to look at some ways you can avoid the fate of “getting stopped out”.
1. Know your volatility
Any instrument that you trade will have its own unique volatility. When placing a stop loss, you don’t want your trade to be closed out just because of some natural daily movement of the price. A trade needs room to “breathe”.
Unfortunately, there’s no magic answer to how much breathing space your trade will require – it will depend on the length of time you expect your trade to be open, and the current behaviour of that instrument.
Take a look at the average daily movement of the instrument you’re trading and be sensible about how much movement you expect the price make between opening and closing your trade.
2. Technical analysis
Many traders automatically place a stop “x” points away from their entry price. While this is a disciplined approach, it’s always worth taking a look at the chart to see if there are any obvious support and resistance areas around this price.
Avoid setting a stop loss just above a clear area of support, or just below an obvious area of resistance. These areas will naturally trigger a lot of buying and selling (respectively) – and you want to avoid your stop loss getting tangled up in this action.
Look to place a stop loss just below an area of support or just above an area of resistance.
3. Avoid round numbers
As a general rule, you want to avoid placing stops at round numbers. For some reason, human beings are naturally drawn to the simplicity of round numbers – and traders are no different. It seems that they just can’t help themselves!
And because so many traders place orders at round numbers, once a price hits a round number it will trigger a lot of activity.
4. Hedging
Hedging provides a different type of insurance policy to stop losses. The purist would say that a hedged trade doesn’t require a stop loss – although personally, I’m more of a “belt and braces” man!
Hedging involves finding two instruments that are closely matched – i.e. their prices move in unison. They don’t need to be matched in the same direction, they could be directly opposed to each other (i.e. one goes up when the other goes down). What’s important is that they are correlated.
Each trade acts as an insurance policy for the other trade. So if one goes against you, the other should move in your favour.
5. Something completely different …
Okay, this is the wild card. A different way to trade that negates all the problems associated with stop losses.
Spread betting lets you profit from a market going up or down. In the most simplistic terms, the more right you are, the more money you can make; the more wrong you are, the more you can lose. And, with spread betting, we use stop losses to control our liabilities.
Fixed odds trading, by contrast, has a distinct advantage over spread betting – your position cannot be stopped out early.
With fixed odds bets, you are speculating on the belief that a particular financial instrument will touch or not touch a certain point within a certain time frame. If you bet that a price will touch a certain level in the next 10 days – it can swing around as wildly as it likes in the inbetween time – as long as it hits that level at some point, you can’t be knocked out early.
Another advantage of fixed odds trading is how easy it is to manage your risk – you stipulate how much you wish to win and you are presented with a trade price based on that value. If the trade goes in your favour, you win that amount. If it goes against you, you lose your stake.
This flexibility alone means that, even if you’re an ardent fan of spread betting, fixed odds can be a very useful string to your bow. And next week I’d like to tell you about a very interesting way of using these bets. This isn’t about making huge portfolio-boosting sums – just an extra £50 here, £100 there – but not to be sniffed at!
Keep a look out for my email on it next week.
In the next seven days …
The week kicks off with a holiday in the States as they celebrate Presidents Day, and purchasing managers surveys in the Eurozone. The later are expected to see continued growth – especially from Germany.
The week will see a focus on house prices. In the UK, we have figures coming out from Rightmove and Nationwide on asking and selling prices. And the British Bankers Association’s mortgage approvals on Wednesday is expected to show figures remaining very low.
In the States, we’ll see the release of the house price index on Tuesday, followed by existing home sales on Wednesday. Again, these are unlikely to bring positive news.
The main story for me is the MPC meeting minutes on Wednesday – traders are anxious to know which way the committee members are leaning with regard to a rate rise.
Finally, on Friday afternoon, we’ve the revised GDP numbers for the UK and the US.
