Using Protective Stops

A classic bit of advice says to use protective stop orders to limit risk and to preserve profits. I always use a protective stop when I place an order. One aspect of my trading strategy is that I won't enter a trade unless I can place a protective stop within $400 of my entry price. This does not mean I limit my potential risk to $400, but in most cases it will be close. If a particular market is very volatile when I enter it (which I try to avoid), it could gap beyond my protective stop and I could actually be stopped out with a larger loss. I try to avoid this situation by entering when a particular market is not having large price swings and by staying out of markets that are generally volatile.

Once I have a position, there are three things that can happen. First, the market may move against me immediately, hitting my protective stop. If I have analysed the risk/reward relationship properly, that is alright. I should have had good reason to believe that the market was going to move in my favor and bring a profit two to three times (or more) as large as my potential risk.

The second possibility is that the market will move sideways and I will have neither a profit or loss. In this case, I will generally do nothing. I had reason to believe the market was going to go in a particular direction and I will wait to see if it goes in that direction or in the other direction.

The last possibility is that the market will move in my direction and I will begin to have a profit. In this case, I need to implement my next strategy. The possibilities are:

To take another position in the direction of the movement
To exit my profitable position
To move my initial protective stop closer to the current price
Do nothing, leaving my initial stop in place

How I act depends on a number of things. If the initial movement from my entry point is very large and very swift such that I have doubled or tripled my margin amount within a few days, I might just exit my position and wait for the market to settle back and look for another entry position. If the movement is less swift, but the indicators tell me that I am trading with the trend, I will look for a good entry point to take another position. The new position will have to meet my entry criteria just as the first position did. I will set another protective stop for the second trade, but will not move my initial stop. My reasoning is that if I am, in fact, at the beginning of a good trend, I do not want to move my stop up and risk being stopped out by a short term movement against the trend.

If the indicators do not show a good trend developing, I may move my initial protective stop closer to the current price and not take a second position. In this case, I may also just keep my initial stop and do nothing. Which choice I make depends on how clear the indicators are relative to the strength of the trend. I like to see the ADX indicator turn up before I would take a second position. If it is trending downward, I would probably wait and either move up my stop, or leave it alone.

If the indicators show a good trend, I will try to draw a trendline that will be my mark to establish further positions in the direction of the trend. I will wait for prices to move to the trendline and then take another position placing my stop just beyond the trendline. This often allows me to limit my risk considerable on further positions.

One common strategy is to move your protective stops up to the breakeven point as quickly as possible. The following examples show why you need to be careful when using this strategy.

In this example, I had a buy signal on February 6th at approximately 257. It was on an upside breakout and I was able to set the initial stop at 252. On February 23rd, the price moved up from a local low and I moved my stop to 255, getting close to breakeven. Prices took a brief dip on March 6th and touched my stop giving me a small loss. Two days later, I got another buy signal and took a position at 258, setting my initial stop at 254. On March 31st, the market had moved up from a local low again and I moved my stop up to 258, or breakeven. I was feeling pretty good at this point, I knew I had limited risk and the trend still looked up. However, on April 18th, the market took a strong single day plunge and my stop was taken out at 258. I felt lucky to have gotten a good fill and not to have suffered a loss. At this point, I was out of the market and no longer sure of the trend. As prices turn back up, I could not find a good entry point where I could limit my risk to an acceptable level.

As the following chart shows, I really wanted to be in on the next move.

It also shows that I if I had waited to move my initial stops, I would have done well. The lesson for me was to take great care in moving initial stops at the beginning of a trend. In many cases I have observed, the market will take dramatic one day moves in the opposite direction before continuing on in the primary trend. In this case it meant the difference between a loss of $200 and a potential gain of over $7000 as the price moved from the 260 area up to over 330 in the next six months.