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Stops Are Not Just For Roads !

Risk And Money Management In FOREX Tradding

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When the discussion turns to the use of Stop Loss orders, you can be confident that a division will occur between all the participants of the discussion, as they are first divided on whether to use stops, and then those who say we should, are therefore divided again on how to use them in everyday trading.

It is with this understanding that you read this article with an open mind. If you are of the opinion that stops are not useful in your trading, rest assured that the author of this article respects that opinion, and merely suggesting that stop-loss orders are important to most traders.

The bottom line, the point of this article, is discussing how we can limit our losses. Every trader experiences losses in trading. Find me a trader that says he never loses, and I will show you a mouth spewing forth lies. Stops are one vehicle in achieving a good risk management plan. Properly placed and allowed to work, your trading losses can be limited, while you let those winners reach your objective.

The argument for using stops is really basic and simple. If you speculate that the market is going to move in one direction, and it goes the opposite way, the stop is meant to get you out before your losses grow any larger. If you did your homework, and I stress that you should do so first, and it is of your opinion that the market is to perform in a certain way but does not, at what point would you finally admit to yourself that your initial analysis was incorrect and you should get out and re-evaluate? If you don't use stops, are you leaving this up to how you FEEL when the market moves against you?

In the past, I personally have experienced the aching feeling of seeing the market move against me, and then when it reaches the price that WOULD have been my stop had I placed one, I would hesitate because I don't want to take a deliberate loss. Then, in my despair, I would watch it go against me more, and more, and more, and.. ...STOP!!!

Well, that is one way to place a stop, but I would not recommend it!

Many will argue that had they placed a stop, they would not have made the profit that they did, when the market finally turned around and went the way they had originally calculated. Yes, this has happened to me as well, and I walked away happy that I did not have a stop in. But this happiness is fleeting and a danger to experience. The win will enforce in you a good feeling for doing the wrong thing. It can turn you into a gambler, one who takes unnecessary risks. I submit that for most who does not use a stop is in essence admitting that he has no clue as to what price against his position constitutes an error. If he had such a clue, he would place a stop at that price. Yet, I must add that this does not apply to all types of trading.

For example, a scalper would not use stops. Why, the time to place and reverse them and so-forth would murder such a trader. He is one that is watching and actively trading the market at such speeds that he isn't going for long pre-calculated moves. He knows his support and resistance areas and is trading off of those, as well as what he sees the action doing.

Another may be a day trader who is merely taking out chunks from a daily range. The action is usually too quick to calculate those stop areas. And just like the scalper, speed is of the essence. However, as a former day trader turned short term trader, I found myself getting chewed up on several occasions where I should have exited when my anticipated move did not materialize, yet to just watch the market continue to move against me for greater losses. All I can say is, day traders beware!

Now we come down to the problem of placing stops. Where should we place them now that we are convinced that we should use them?

This problem of placing stops seems to stem all the way down to the Municipal level. In the city where I live, they seem to have stops all over my neighborhood. It seems that they don't have a clue as to where to place their stops either. I imagine that if they were traders, they would over use stops to the point of many losses over time.

There are volumes of books on the subject of trading. But have you ever noticed that when it comes to the subject of stops, they many seem to fall short of stating exactly how they should be placed? Reason may be that there is no exact way to place a stop. Yet, this will not stop the trader in trouble from continually asking the next guru in line, "Where should I place my stop?"

I'm going to share with you some suggestions for stop-loss placement. Of course it won't be the best for all situations, that will require trial and error on your part. However, for many situations, it should work relatively well.

First, to limit my risk, I trade only on time days. There are various ways to calculate time, each with their own accuracy levels. Those familiar with my work know that I use Fdates ( for my time days. But you are free to use whatever method you choose. As a matter of fact, you don't even have to use any time days if you don't want to. That is just my own preference. You can still apply the stop-loss methods to your own way of trading.

The purpose of using time days is to limit my initial risk exposure. I want to get into a trade as early as possible to the beginning of a new move, so I will know where to place my initial stop-loss. Suppose that yesterday was a time day, for example. It made a lower low than the day before. So maybe I believe it is going to put in a short-term bottom. I could just buy into this market the next day, but if I am wrong about the bottom, it is throwing good money away unnecessarily. My solution? Simply to place a BUY STOP order just a tick above the high. If the market fills me the next day, then it must be moving higher and my time day bottom may be correct. If I am not filled, no harm done.

Now, suppose I'm filled. I immediately place my STOP-LOSS a tick below the low of yesterday. Why? Because if it goes lower now, then my bottom isn't really a bottom, is it? I want to get out cheap! Alas, the STOP-LOSS is there to keep my expectations honest. If I am right, I am filled. If I am wrong, I'm likely not filled. If I'm filled anyway (such as an outside price range day which happen a low percentage of the time), I'm out cheap. See why I value stop-loss orders?

Now, this is just the initial stop-loss, mind you. The hard part is the EXITING of a trade. Some use profit objectives, others exit at the next time day, and some simply trail their stop by some fixed amount. I like to use a couple of other methods instead.

Let's discuss the first one, shall we?

Say you want to go the longer-term route. You want to milk this trend for all it is worth. You have waited patiently for a weekly bottom to start forming based on some indicators you use (mine would be Wdates). You've fine tuned your entry with a time day or some oscillator you like to use. Whatever the method, you are now long with your initial stop-loss placed.

One option is understanding trends. A good bull trend forms a pattern of higher swing bottoms, one after the other. Knowing this, you can keep your stop-loss at the initial location until the market makes its first top and starts to correct. You can make sure you move your stop-loss to breakeven at this point, and wait to see how far it will correct back. Once the correction is completed and price resumes its move up, or even exceeds the first top in price, your stop-loss can then be moved up to just below that first correction bottom. This you can do until stopped-out.

Another option to this approach is to initially keep your stop-loss at least 65% back from the currently highest top from your entry to the beginning of each new up move. A good bull move usually will not retrace more than 62% off any top. If you can identify major corrections based on the degree of bullish waves (requires experience in identifying waves), after the second major correction has completed, you will want to abandon the 65% approach and start tightening your stops to capture more of the last wave or so.

Another approach to stop-losses is using moving averages. There are a few ways to do this. One approach is to plot a 18-day moving average on your chart. Once the value of the 18-day moving average exceeds the price of your initial stop-loss, you would then place your stop-loss just under the 18-day moving average with a few additional points to give the market some leeway (quick dips below the moving average, for example.) You can also experiment with the value of the moving average on the last trend of the same market, to get an idea of its characteristics. Maybe a 13-day or 21-day would suit that particular market better. Only you can decide this.

Another approach is using trend lines. Once the first major correction occurs, you can then draw a pretty reliable trend line and use it as a reference for your stop-loss placement. If you notice the market changing its angle in relation to this trend line (becoming steeper, for example), you may wish to adjust your trend line value accordingly, since most parabolic moves are met with an equally fierce move in the opposite direction, 'against your position'! Play it smart and anticipate.

I have noticed over the years that each market exhibits a unique behavior in pattern. Some markets trend smoothly most of the time while another jumps all over the place and is very volatile. Experiment with the market you wish to trade and see which approach captures more of the previous moves. It will provide you with excellent clues on how to tackle the future moves as well. What better template could you have than a markets repeatable behavior?

We dealt with a market going up, but just reverse for a market going down. Simple. Now if I only can get the city to remove many of their stops, I'd be a happy camper!

Note: About the Author
Rick J. Ratchford is President of ProfitMax Trading Inc. He is a full-time commodity trader for his own account as well as assisting other traders. He has been a computer programmer for more than 20 years and a trader since 1990.


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