In this article we will discuss the various ways to implement a stop loss order. Every trader who has had dealings in any of the financial markets is familiar with placing and executing a stop loss order, but many are mistaken that a stop loss order is always numerical. On the contrary, there are many traders (even professional hedge fund managers) who use what is colloquially termed a “mental stop” which stop is a stop loss point determined by factors other than the price, such as events, volatility, volume, option positioning, or any other comparable data. Such a stop is no less valid than a numerical one, and certainly no less effective, but one does need a lot more discipline to execute it successfully.
The great advantage of a non-numerical stop-loss order is its partial immunity to price swings. If the trader has confidence in his analysis, and is satisfied that standing firm in the face of market volatility is sensible and acceptable given the major dynamics and currents in the market, maintaining positions with non-numerical stop loss orders can be advisable and lucrative. In order to manage the inevitable large swings in account value, professional managers will implement hedging strategies in addition to money management methods, to control and minimize the volatility of the portfolio. Thus, even if the mental stop triggers a large drawdown in our position, we can minimize the effect on the portfolio through diversifying and distributing the risk among various currency pairs.
Let us examine the various ways of implementing a stop-loss order now.
An equity stop is one where the position will be closed in case the total equity in an account falls below a certain value. A stop loss at 2 percent of total equity is generally regarded as a conservative strategy, while the maximum is 5 percent for most money management methods. Thus, to give an example, a 1000 USD account would have the stop loss for an open position at the point where to the total equity would fall below 980 USD.
Both the disadvantage, and the advantage of the equity stop is its inflexibility. The equity stop provides a very solid criterion for deciding on the success or failure of a single trade, as there’s no way of being mistaken about an account in the red. On the other hand, the same inflexibility may prevent the trade from functioning as expected. The markets are volatile, and a trade that has a perfectly valid cause behind it may yet be invalidated by the random fluctuations that are not predictable.
Another important problem with the equity stop is its inability to prevent a string of losses. For instance, when the trader closes a position at a two percent loss, there’s nothing that will prevent him from opening another position in the same direction (buy or sell) a short while later, if the causes that justified the first trade are still in place. For instance, if the trader enters a sell order when the RSI is above 80, and consequently the stop loss is triggered, and the position closed, there’s little that will prevent the same events from being repeated if the price action repeats the same movements. In order to avoid this pitfall, the trader can tie the stop loss point to a non-price factor, and the rest of this article discusses such scenarios.
In a chart stop, the trader will place the stop loss order not at a price point, but at a chart point which may be static or dynamic. For instance, a stop loss order may be placed at a fibonacci level, which would be a static value. On the other hand, the trader may use an API (an automated trading system), or mentally prepare himself to close the position if a technical event, such as a crossover, a breakout, or divergence occurs, which would constitute a dynamic stop-loss point. In all these cases, technical analysis generates the triggers and determines the price where the position must be closed.
The chart stop is more flexible and reliable than a direct equity stop, because it adjusts to price action and volatility, and is therefore somewhat independent of the random movements of the price. The problem with the chart stop is twofold. First, the technical indicator used to generate the signals may fail to capture the change of the market trend, resulting in large losses. The other, and obvious problem is related to the indirect character of the stop-loss mechanism. Because the order is independent of the price, it may not be able to cut losses as effectively as a direct equity stop, and larger than expected losses may materialize as a result.
A volatility stop depends on volatility indicators, such as the VIX for determining the exit point for the trade. As such, market panics and shocks will cause the order to be executed, but mere price fluctuations in the currency market which lack their counterpart in other asset classes will be ignored for the most part. The trader who utilizes a volatility stop expresses the opinion that unless a major, unexpected shock hits the market, his position should be held regardless of the behavior of the markets. This is a more risky strategy than the equity stop, but can be profitable and valid depending on market conditions and the economic environment. In general, it is doubtful that a volatility stop can be very useful in a very nervous and volatile market. But it could be very helpful in maintaining a long-term position where risk perception is low.
The volatility stop is sensitive to prices, but only in an indirect manner, and its nature is similar to the chart stop. It is useful for eliminating very short term distortions from our analysis, and allows us greater resilience in the face of noise in the data.
Volatility may fail to react to market swings. Sometimes a large fall in the market has no equivalent rise in the various volatility gauges. Similarly, volatility can at times rise without any obvious corresponding price action. Consequently, a volatility stop (and similar stops based on non-price data) can be triggered even before a trade is in the red. All these must be kept in mind if the trader decides to use this type of stop order.
When the trader expects an ongoing trend to be reversed or invalidated subsequent to a change in volume, a volume stop maybe appropriate. While volume statistics are not available for the forex market, positioning as depicted by the COT report can be used for establishing this type of stop. For utilizing the order, the trader determines a percentage value on futures positioning above or below which the position must be liquidated, depending on market conditions and the nature of the order. In the same context, other types of data can also be used to generate a stop loss trigger point. A particular put/call ratio, or option risk reversal value may all be chosen to provide the equivalent of a volume stop in the stock market.
In example, let’s consider a trader who opens a short position in a carry trader pair, confirming his trade by developments in the stock market. His expectation is that the recent rise in the stock market indexes (and the corresponding rise in the carry pairs) occurred on low volume, and will soon be reversed in the absence of new money flows. Consequently, he places his stop-loss at a volume level which, if reached in a rising market, will invalidate the starting premise, and cause the position to be liquidated. When this occurs, and volume rises above the preconceived level, the trader will close his short position in the carry trade pair.
The margin stop is not really a stop loss order, but the absence of it. In this case the trader will let his account absorb the unrealized losses until a margin call is triggered, and a large part of the account is gone. The margin stop is a sign of indiscipline and lack of insight, because a diligent trader will always predetermine the conditions that will lead to the closing and liquidation of a position. Since not even the brightest analyst is capable of predicting the future with any certainty, lack of a stop loss order is an indefensible practice.
Notwithstanding the previous, the margin stop is a popular choice among many traders who are unable to remain calm in the face of the great emotional pressures of trading. It is only viable under really low leverage such as 2:1, and even then a margin stop would not be the best choice. At much higher leverage, the margin stop is completely indefensible, and should be avoided altogether
Fundamental analysts do make use of technical tools, if only for determining the trigger points for a trade. Take profit, and stop loss orders are used by almost every trader in the world, and its is unthinkable that a serious analyst will not have a condition, at least in mind, for closing an open position, however convinced he may be of its ultimate validity.
But fundamental analysts are not limited to technical tools and the price action for determining when to exit a trade. The event stop that we would like to discuss here is a tool that the trader can use to determine a trade’s exit point.
When using the event stop, the trader will ignore the price action for the most part (and will use low leverage), and will only close a position in the red when the scenario he had pictured in his mind becomes contradicted by events. For instance, a trader is anticipating that Bank A will be nationalized by the authorities of Nation X, and he expects that this will lead to X’s currency depreciating against its counterparts. In consequence, he shorts it. He will refuse to close the position until authorities confirm and clarify, in a solid and unmistakable fashion, that they will refuse to nationalize Bank A. In the meantime, he will be willing to put up with all the rumors, extreme swings, and short term fluctuations in the market without worrying about the unrealized profit or loss in his account.
As we mentioned at the beginning, the event stop is for those traders who know what they do, and who possess the track record, the intellectual background, and the confidence to use it. But do not take our word in order to evaluate your own skills; you should know yourself better than anybody else, and if you believe that you understand the economic dynamics of the era, and can defend your claim in your trading activities, you will be perfectly capable of using the event stop.
The best choice for the beginner is the equity stop. During the learning process, the trader can concentrate on bettering his understanding of the markets without worrying about excessive losses. Once the trader gains a good understanding of market dynamics, and is able to form and implement his trading plans, the equity stop will quickly lose its attractiveness.
The best method for using the non-price stop orders is combining them with a wide equity stop which will serve as a final safety precaution in case the price action becomes too dangerous. For instance, a trader can long the EUR/JPY pair and hold it indefinitely until the VIX registers a value above 35, where a volatility stop would be placed. At the same time he will protect himself from extreme, and unexpected swings by placing an equity stop at 5-7 percent of total equity. Thus, unless a very large price swing completely overruns the main criterion for the stop loss order, and triggers the equity stop, the trade would be maintained indefinitely.
Needless to say, every trader will have his own choices on stop loss orders. And we would like to conclude this section by noting that the key to a successful stop-loss order is a disciplined risk management strategy, and everything else is just detail.