Almost everyone has heard of, or uses trading stops to prevent investment losses. But have you considered the key ramifications of how you use stops?
Traders know they can put a “trailing (or high) stop” on a position with either a set figure or a percentage. So the questions start with how do you decide what amount or percentage. But that is just the starting question because there are more; in fact here are the questions to consider in using stops:
• Why use stops
• What type stops
• Are all stops equal
Why use stops – the common answer is to protect yourself from losses. But there are more reasons or perhaps it can be said that stops should be looked at with a different attitude. I like to think of stops as having three functions”
• Stops lock in my profits so that when an ETF starts to drop from its high point I still make money. This way if the ETF is climbing and then starts to drop I know I am still going to make a profit because I’ll get a sell signal or automatic trade based on the percentage drop from the greatest high the ETF reached since I purchased it.
• Stops prevent me from losing too much money when I set a stop below my purchase price. I may want a 3% or 5% stop below what I paid for the stock so if it tumbles my risk is limited to just that amount.
• Stops help control my trading frequency if I set them based on the type of ticker symbol, the type of group the position comes from, and how often I prefer to trade. In other words a tight stop of just a few percentage points is going to result in more frequent trading while a higher number, say 7% or 9% will result in fewer trades and perhaps less volatility in my portfolio.
What type stops – you have a choice between using a set dollar figure or a sliding figure based on percentage. The set figure works great or just as well for a stop based on the purchase price to minimize your risk of losing money. But unless you want to be constantly updating your stop a set figure doesn’t work very well for a trailing or high stop; in this case a percentage based stop is the best way to go.
Are all stops equal – stops have multiple influences besides just being a point at which you may sell a position.
The personality of your strategy or group, the characteristics of the individual ticker symbol can all have an influence on what setting can or should be used. An ETF or ETF group strategy that bounces around a lot, but within a tight range would lead you to frequent and possibly unnecessary trading if you had tight stops like 2, 3 or even 4% whereas stops of 6% to 9% will still allow you to lock in profits but avoid the frequent trades from erratic movements within an upward climb.
If however, you want to trade frequently, minimize risk and make money on small profits then tight stops make absolute sense.
Some software program will allow you to create strategies for different groups and test what stop settings produce the best results. The results from such testing will prove that using a standard setting does not produce the best results.
There is a pitfall to using automatic stops that kick in with your broker. There is no guarantee your position will actually sell at your stop price because if the markets are extremely volatile or there is a shortage of buyers you could find yourself selling for a substantially lower amount then your stop setting. This is why some investors simply have their investment program give them sell signals which can be based partially on stops so they can pick the time to sell.
In any event, to totally ignore stops would be dangerous because you are putting your investments at total risk without any warning device to help you preserve your original money or your profits.