Stop Placement Trade-off: Personal Observations

Mar 2, 2007: 3:46 PM CST

Ever wonder the exact place to rest your stops?

Sadly, there is no exact place and there is no magic formula. Placing your stop involves a trade-off between risk (in dollars) and probability of being triggered. Simply put, the closer your stops are to your entry, the less you risk, but the higher the probability of being stopped-out due to normal volatility. The further your stops are from your entry, the lower the chance of being hit, but the more money you will lose (unless you properly used position sizing).

These can be mathematically calculated and affect the end-result of any trading system. There is a difference, however, regarding this issue in mechanical vs. discretionary trading systems.

A mechanical system trader accounts for this, tests various methods for stop placement (Average True Range functions, swing highs/lows, moving averages, etc) and attempts to find the best trade-off. Results are derived from normal market movement and choice of entry/exit criteria.

A discretionary trader experiences a ‘double whammy’ when it comes to stop placement and end results. Emotions and discipline are factored into the equation in a non-linear, non-mathematical method that results in various outcomes that cannot be predicted. Stop placement becomes subject to the whims and emotions of the trader at the moment the trade was placed. Also, a discretionary trader may impulsively decide to move his or her stop either up or down and further degrade (or improve) the monthly/weekly results.

The outcome of one trade has little impact on overall trading performance, if a trader follows discipline and a tested system. This is difficult to comprehend for newer traders and experienced ones alike. As a discretionary trader, I still put too much emphasis on the current trade and wonder whether my stop will be “gunned” or if I placed it too far (and thus, should move it up mid-trade).

My problem occurs from entering a trade, placing my hard stop, then yanking it up to kill the trade when the market moves slightly against me, or remains ‘stuck in neutral.’ I have found this to degrade my performance and increase psychological stress on me – rarely has moving my stop been helpful.

I have noticed many times that the market – regardless of timeframe or strategy – will signal a clear buy signal, move in the intended direction, stall, reverse, trade down at the ‘obvious’ stop-placement level, take out close stops, and then rally very quickly in the original direction as traders rally to get back in. I’ve been stopped out with “the crowd” more times that I care to admit and it’s due to “fear of being wrong” and my perfectionistic tendencies.

I will be writing an article soon to address this point and show examples of why both tight stops and loose stops degrade system performance, as well as moving stops based on emotion.

Please comment or contact me with your experiences and insights you have had with good and bad decisions related to stop placement. I look forward to hearing from you.

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