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© Copyright 2006, 2007 and 2008 by Jeff Quinto All Rights Reserved
May 3rd, 2008 at 8:24 am
Stops are, to me at least, are one of the most difficult and controversial aspects of trading. My broker, decades ago, was fond of saying “You are damned if you do and damned if you don’t.” Not a very profound declaration, but it expresses the dilima very well. In the days of the pit locals vs. the public, the former made their living at the expense of the latter by “running the stops.” This was only possible because the public put the stops there in the first place and the act of running did create volatility and excursions and, hence opportunity.
Why does the hitting of a stop have the potential to cause anguish and conflict in the mind of a trader? Because, on the micro level, it represents a failure. Things did not work out as the trader had planned. A battle in the war has been lost. A fuse has blown, the house was saved but we are left fumbeling in the dark.
Negative aspects not withstanding, there is not a trader in the world who does not use stops in some form. If not decided and entered in advance, then in utter despair when the pain and anguish of adversity becomes too overwhelming to endure.
The question then, is not whether to use stops but where to put them. There are two answers to this question. From the market’s perspective, the stop should be placed where it will not be hit unless the entire rational for the trade is wrong, definitely not within the envelope of “noise.” From the traders perspective, the stop must be placed so as not to overtax the traders means and within the envelop of his psychological toleration.
It is certainly a very noble objective to use a very tight stop and not to take any more “heat” than is absolutely essential. If the market were as we would like it to be, this philosophy would work beautiefully. We put a stop at minus five, the market is moving against us, we are taken out with a small loss as the market continues to move to minus ten twenty and beyond.
The problem here is that the real market seldome behaves this way. At the micro level, there seems to be an element of purely random ebb and flow to price action which is always present and superimposed over the markets true direction. When we place a trade with a tight stop we will often see a tick sequence something like this: 0, -2, 1, -3,0, 2, -1, -4,-2, -6, -3, 0, 3, 2, 4 ,7 and away. with a tight stop, we have no opportunity to get back in more advantageously. We are spun to the sidelines and the trade goes on to great things with out us.
Are we better served by wider stops? Not necessarily and probably not. Trading is a statistical game of probablilities. if our stops are being hit more often than we would like, there are two inter-related reasons, either our stops are unrealisticly tight or we have not analyzed the price action correctly and accounted for the affect of the random noise on price excursions. With tighter stops our analysis must be near perfect or we will be spun to the sidelines, with wider stops our analysis can be more sloppy and we can still stay in the game but the price of being wrong will be greater. If a blind man were to try driving a car he would be far less likely to hit an obstacle on a golf course than on a windy country lane. The problem here is that we can not precisely analyze the future we can only form a stistical opinion about it based on history.
In hindsight, for any given market senario, there is always a “correct” stop level which would have allowed us to protect our capital while the market works its way toward our objective. It is our job as traders, to predict, in advance, just where that level is.
There is no right answer, it varies from market to market, trader to trader, and minute to minute. You must find something that produces good results for you and use it. Larry Williams was once asked a question about trading size. He said he didn’t know; when he was winning he never had enough trades on and when he was losing he always had too many.