Stops can be can be particularly useful when markets are volatile
One of the most useful tools for any trader especially of derivatives is a stop loss order.
Stops are user-defined points where a trading position will be closed out. When financial markets are volatile they can be particularly useful.
While the name suggests that a stop-loss order is designed to stop a loss, in reality a better description is managing a potential loss in the event a trade goes against you.
If you open a trading position at a particular price, says technical trading adviser Jim Taig of Seismo Trading, you should protect yourself against the possibility of making a sizeable loss by nominating a price level where you will close the position out, thereby limiting any loss.
All stops, says Taig, should be linked to a trader or investor’s money management approach given that trade management is one of the most important considerations for investors and traders.
Taig, who identifies trading ideas via his Seismo technical trading platform, always accompanies each recommendation with an initial stop loss suggestion when trades open and then trailing stops to protect rising profits.
Depending on how the recommendation will be traded, the initial stop loss is based on risking no more than 20 per cent of an initial margin amount on a contracts for difference (CFD) trade or 2 per cent of an investor’s trading capital where it is a direct share trade.
For more cautious traders or investors, stop loss levels may be equivalent to risking no more than 1 per cent of trading capital.
As far as trailing stops on long trades are concerned, these same rules are applied when moving them up as prices rise.
Broker Hamish McCathie of Pulse Markets uses another loss management technique described as a “stop on close”.
The technique employs technical analysis to set price levels that determine the stops. Where it is a long position this will often be the most recent low and where it is a short, a recent high will often set the level.
The idea of having a stop on close allows for daily volatility and a chance to remain in a trade if the volatility is such that a price may hit a stop during the day but return to a level at the close where the position is still viable.
McCathie quotes some recent action involving oil market leader Woodside which was trading at $49.22 in early November when he suggested the price could fall. He nominated a short trade with a target of $47.86 but also a “stop on close” level of $50.26.
Several days later the shares opened strongly at a price of just under $51, well above the stop level. However by the afternoon the price had retreated back to $49.75 which saw it once again under the stop loss level.
McCathie says that with a short trade it is quite often the case that a market will behave in a volatile way, opening beyond the stop but then closing below this.
Why this can happen is often because a lot of the daily activity takes place during the morning when traders or investors react spontaneously to any previous day or overnight market action.
But as the day progresses, he says, traders often look more closely at market influences and will frequently re-assess any market action, they will then adjust prices.
One aspect of his stop loss system that McCathie acknowledges is the chance of greater price slippage if prices at the close happen to go well beyond the stop loss level in a short trade or below the stop in a long trade.
From his experience however, it is a strategy that does give more chance to staying in a volatile trade. With standard stops, positions that end the day within the stop range will often be closed out before the close.
