Trading

Education

All Stopped Up

(This is the seventh in a series of articles on basic technical analysis originally published in Futures magazine.)

One of the secrets to success in futures trading is not how much you win but how much you keep from losing. Almost any trading method will produce at least some profitable trades. Whether you are around to take advantage of those profit opportunities depends on how well you preserve your trading stake. Professional traders emphasize that you must minimize risk on every trade. Translated: Cut your losses quickly. Translated further: Always use stops.

Stops can’t be too far from the current price or the risk is too great. They can’t be too close, or you will be knocked out of your position before the market makes the big move in your favor. You should put a stop in place to exit whenever you get a confirmation that you have entered a new position, but you aren’t a very experienced trader if you don’t have a frustrating story about using stops -- either ones that were filled or ones that weren’t.

Stops are generally considered protective devices and are frequently placed at logical technical analysis points. That is, they are often placed at a high or low or at a trendline breakout point that, if violated by price action, would change the outlook of a chart. Other chart patterns can also provide stop locations.

The accompanying chart of S&P 500 Index futures shows a pennant formation followed by a downtrend. Stops could have been placed above and below the little pennant’s trendlines to enter the market in the direction of the breakout. Once the breakout occurs and a short position is established (at approximately 1501 in this case), some traders would place their first protective stop at the high; others would put it at the apex of the pennant (A) as their escape point.

You could ride the trendline down, getting out of the short position with a buy stop when the market breaks above 1490 or so (B). As you watch the bottoming action and decide to go long, you could place a buy stop above the interim high, getting long at 1493 (C). To protect yourself, you could place your initial stop below the low (around 1488), a risk of 5 points (or $250) in the E-mini contract. As the market moves above C the second time, you could move the stop up as the market moves up. This is an example of a “trailing stop” (1, 2 and 3) that moves with the market to reduce your risk and eventually capture profits (in case the market turns on you).

These stops, both entry and protective, are based on typical technical signals. Stops can also be based on an amount of money, either a set amount or a small percentage of your account. Sometimes, a logical technical stop point has too much risk. If the low at D had been 10 points lower, for example, the risk of 15 points (or $750) for an E-mini contract might have been more than you wanted to accept. You might arbitrarily have set a 10-point (or $500) stop as the limit of your risk. Or, you might set a limit of 2 percent of your $20,000 account (or $400).

Another type of stop is one based on a profit objective. Rather than take a chance on the market hitting a point and then reversing some distance before giving a signal, you might be satisfied with a $1,000 profit on a trade. If you went short on the pennant breakout in this example, you might just say, “Buy at 1494 or better.” (E) and take your money off the table while you can. This is not a protective stop, of course, so you still need a stop above the trendline, but a profit target may be the difference between a winning and losing system.

Several other comments about stops:

• As a general rule, whatever looks like a good entry point is probably also a good exit point for those already in a position.
• If the location of a stop seems to be so logical and so obvious to you, it is probably obvious to the rest of the world, too, and you may see erratic action and poor fills if everybody tries to do something in that price area.
• Stops do not guarantee a fill at the price you specify; in fact, a fill could be far from your price.
• You should change a stop only to reduce risk, never to increase risk.

You may not need to use stops if you use a reversal system that is always in the market or if you use options to offset the risk in futures. Whether you use stops or some other method, however, your first concern as a trader should always be to reduce risk and preserve your trading stake.

Next article: Buying bottoms

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