by Griffin Cooper
I was talking to one of my friends the other day who is a trader and he was exasperated, he was really struggling. As I talked to him more I started to figure out what was going on, and I realized that he was making what I believe to be one of the biggest mistakes you can make in trading. He was trading without using stops.
This article will go through all the things you need to know about stops: what is a stop; how stops are the biggest separator between amateur and professional traders; why people don't set stops (hint: pychology!); the dangers of trading without a stop; and then the benefits of trading with a stop.
Then we’ll go through an example of a pattern from our Kata Challenge, part of our Applied Systems Development Course that shows exactly how we set stops using price action and specific indicators. So let's dive in.
What is a stop? A stop is simply a worst-case exit point. It's the price where you know that you'll exit the trade. And here's the important part: It's set before you put the trade on. It's called a stop for a reason, because the stop is the place where you’ll stop losing money. It’s where you’ve decided that the trade isn't going in the direction that you want.
The use of stops can apply to all time frames of trading. It doesn't matter if it's a daily or monthly chart or a minute or tick chart. It also applies to all types of financial instruments from Forex to stocks to crypto (especially crypto!). Setting stops, or any process that you have to cut your losses, is really to me the biggest separator between amateur and professional traders.
Now there are different ways to do this. The way we do it, our methodology, is to use stop orders in the market when we put on a trade. Different professionals use different ways of cutting their losses. But we’ve found the best way to do this for our kind of trading is to use stop orders in the market.
The psychological part of this is that we don't believe in the trade. We have a saying we use here that “You don't have to be right, but you can't stay wrong too long” too. There's a great series of books by Jack Schwager called Market Wizards where he interviewed all the best traders. Some traded stocks, some bonds, some commodities. There were trend traders, scalpers, all kinds of methodologies. But the one thing they all had in common is that they all had a way of knowing their risk and cutting their losses.
If stops are so essential, why would people not use stops? This is really about trading psychology and probably the most important part of this article. The reason that I think people don't use stops is because they're mesmerized by the possibility for huge profits. They're not thinking about the possibility of losing money. What it really comes down to is that they believe they know what's going to happen next.
This is a really dangerous way of thinking when you're trading, because the truth is that anything can happen in the markets. It doesn't matter how good your technical analysis or your system is. It only takes one trader to move the price against you in an instant. The truth is, you never know, anything can (and will) happen in the markets.
What are the dangers of trading without a stop, and what are the benefits that you can enjoy when you when you trade with stop? The biggest danger when trading without a stop is that your loss potential is unlimited because if you don't have a place you're going to get out on the trade. You never really know how far it's going to go down. Anything could happen in the markets. You’re making your loss unlimited. A lot of professional traders say they believe there's always a trade with your name on it that can wipe you out.
I know this from experience when I was first learning to trade. I was trading credit spreads and I put on a trade on American Airlines without a stop. I went out for a jog and by the time I came back I was down over 10 times what I was trying to make on the trade! That was the first time that I realized how important stops are to protect your capital.
A good metaphor that people use for trading without stops is that it's like driving a car without stopping at red lights. It'll work for maybe a little while, but eventually you're going to have a huge collision, a huge loss.
What are the benefits of trading with a stop? The biggest advantage is that you always know exactly what your risk is. You're essentially cutting your losses, and that means you're following the first part of what we call the golden rule of trading, which is to cut your losses and let your profits run.
Another huge benefit about when you trade with stops is that you can start evaluating, assessing and improving your trading results based on the amount of risk you're taking, or the “R” multiples. A discussion about R multiples as a function of risk is out of the scope of this article, but when you're using R multiples in your trading you can analyze your trade results across any selection of symbols, whether you're trading gold or the Aussie dollar or Tesla. You can compare your results across different time frames, from a daily chart to a 3-minute chart, and you know can analyze results across different systems as well to see which systems are performing well. When you start to do this now, thinking in terms of risk and reward, then my friend you are thinking like a professional trader.
Here's an example of how we use stops to cut our losses in the Kata Challenge. It's simple, it's easy to understand and it's based on technical analysis that uses specific indicators tuned to statistically significant turning points. Here's an example of our Supported Spring Crossing pattern on a daily chart using EW, the Brazilian ETF.
The green dot is where we bought and got long. The big red horizontal line is where we put our initial stop loss in the market at the same time we executed the trade. We use a special version of the parabolic stop and reverse, the PSAR indicator, using linear regression lines to find the specific point that is statistically significant to show us when our trade is not working, and we can get out and cut our losses. This is just one of the three basic patterns we teach, but we do this on every trade.
Happy trading everyone, and don’t forget to set those stops!