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Why You Should Use Stops When Trading

Online Trading Academy
Wed Jan 15, 2014 10:03 EST

Retail traders and investors don't implement stops for many reasons. Some don't even know what a stop is and don't know any better. Others refuse to use them because every time they place one in their trades, they always seem to trigger right before the market takes off in the correct direction. Another motive for not using stops is refusing to accept that some of the time we're going to be wrong. You would think that being wrong some of the time is a common reality for most traders; however, you would be surprised how many traders don't operate this way.

So why use stops when trading? Would you walk a tight rope without a net? Would you jump out of an airplane without a parachute? If you did, it would only happen once. Admittedly, most of you won't be walking a tight rope, nor jumping out of an airplane anytime soon. However, anytime we engage in risky behavior, don't we always have some type of safeguard to protect us from catastrophe? Why do you buy flood or fire insurance against your home? The same reasons we protect ourselves against a disastrous event in other areas of our life are the same reasons we need to have some type of stop loss on our trades.

Let's now address the most common question: Where should a stop be placed to give it a higher probability of not triggering? First, notice that it's about odds, not assurances. We have to accept that some of time we will be wrong and our stops will be triggered. This is just a cost of doing business.

A stop order serves two distinct functions. First, it allows us to clearly define our risk in every trade, and second, it delineates the lowest risk entry point. In other words, since the stop is going to be placed close to the chart price where we will be proven wrong, the closer we enter to that price, the lower the risk on the trade.

Below is a recent example in the Mini Russell 2000 futures contract, where we see it formed a supply zone (highlighted in yellow). This zone created a low-risk entry point for a shorting opportunity. The entry is to be taken at the origin of the imbalance as we anticipate that the price of the Russell will fall once it reaches this level of imbalance.

TF SET 01-09-2014

The stop is placed only a few ticks above the highs of the zone because that is point where all of the sell orders will be absorbed and where the trade probably won't work. As you can see, the risk is very small, the probability is higher than average, and the profit margin is high. Therefore, it's a good trade.

In the next chart, we can see that the trade worked as planned, but if it hadn't, the risk was very small as we had a stop to protect us in the event it continued to climb to an all-time high. If you had shorted the Russell, and did not use a stop, then you would just be guessing as to how high it would go, and that, in my assessment, would just be gambling.

TF SET result 01-09-2014

Most of you, I'm sure, have heard the adage "Pulling all the Stops." That meaning is good in most endeavors; however, in trading, pulling all the stops can spell disaster. Stops are a must in executing a low-risk strategy. If you are getting stopped out too often, that is probably a function of the strategy that's being implemented, and as such, it needs to be reexamined. At Online Trading Academy, we might be able to help in that area, so please contact a center near you to explore some alternatives.

Until next time, I hope everyone has a great week

Editor's note: This story by Gabe Velazquez originally appeared on Online Trading Academy.

To read more from Online Trading Academy, see:

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