Don't Stop Me Now!
|One of the most common questions I have asked of me is where a trader should place their stops for maximum effectiveness and still not be stopped out too soon by normal market fluctuations. A specific question posed to me was:
Q: My biggest problem is that I do not know where to set up my stop losses without being taking out too early or too late. Is it true that a Market Maker can see all of the stop losses in their computer and move the price around that to benefit them?
A: To answer the second part of your question, yes and no. The market makers can only see stops that are placed on their own system from their clients. So ScottTrade’s market makers know where all of ScottTrade’s clients are placing their orders. This is one reason why Online Trading Academy teaches trading through Direct Access brokerages. If you place a stop order on a direct access trading platform, the order is usually held in the brokerage’s server and is not seen by the market or the other market makers until it is activated. You must know your broker’s stop policies however. There is a different type of stop order routing that is used by some direct access brokerages. This stop order is routed to an ECN and held at the ECN server until activated. This type of order may be seen by all who subscribe to that particular ECN. The ECN, AUTO is one such ECN that will house orders.
Remember that market makers are smart. They do know that most people will place stops around whole, decade, or century numbers and will “run” the stops to shake you out. You should also place stops NEAR supply and demand, not AT supply and demand for the same reason.
Setting proper stops can be tricky. You should always maintain the 3:1 Reward to Risk ratio or do not take the trade. Identify your entry point, your exit point, and calculate your potential profit for the trade. Divide that number by three and that should be your minimum stop loss. You can also refer to the AverageTrueRange to see if your stop is too tight for the time frame you are trading.
For example, the potential trade in the chart below shows a possible short with a profit of $5.40 (Short entry at about $195.46 and exit near $190.06).
The ATR for SPY every 30 minutes is only $0.61. We could take the short with a stop of about $1.80 and not fear getting stopped out by the volatility of the ETF.
For swing trades, I use similar criteria. A trade with a $3.00 potential profit and a $1.00 stop may get stopped out too early if the ATR is $1.75, but may be ok if the ATR is $1.25 or less. I also look at doubling the ATR and using the smaller of the ATR x 2 or 1/3 of my potential profit.
Another type of stop is the Chandelier exit which was featured in Technical Analysis of Stocks and Commodities magazine a while ago. It involves multiplying the ATR by three and subtracting that number from the most recent high (or low if you are short). Just remember to maintain proper risk vs reward ratios (3:1). This type of stop works best in trending markets.
Here we see SPY pulling back to demand on the daily chart. When we go long at demand, we set our initial stop below demand.
Changing the stop can prove challenging as well. Once you clear breakeven, you may choose to move your stop high enough to cover exit with no loss, even covering commissions! If another swing high presents itself, I usually move up my stop to protect any profit.
In the above chart we had a pullback from a new high of $92.98. A check of the ATR at that time shows $0.71 Daily ATR. We multiply that by three and hang it from the high. This gives us a stop of $90.85 which locks in a gain even if prices move against us. Every time price makes a new high and starts to correct, we can repeat the process. Doing this creates more profitable trades in the trend.
These stop guidelines would work on any type of security. We can use them in trading currency, futures, commodities, and of course stocks. I hope this answers some of your questions about stops.
In our courses at Online Trading Academy, we teach traders and investors the proper methods for placing stops and protecting their money. Stop into your local office to learn more.
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