Setting Stop LossesRisk Management
Traditionally, most retail traders and investors utilize the principle of a “stop loss”. A Stop Loss place an order at a specific price level that will automatically close a trade if the price reaches that value. A stop loss on a purchase will be a sale to close the order at a certain price. Traditionally traders set this stop below the most recent swing low. A stop loss on a sale will be an order to buy above a certain price, traditionally the most recent swing high.
Stop Loss Hunting
The biggest issue with a stop loss is a fairly common phenomenon known as “stop hunts”. A stop hunt on a long purchase occurs when the price will suddenly spike down to trigger stop losses before rising upwards, robbing long purchasers of profit. Alternatively, a spike up triggers stop losses on short sales before falling downwards, robbing the short side of profit.
Why does this happen? It’s a simple liquidity issue. Big Hedge Funds and Investment Banks attempt to get what is known as “Best Possible Fill” for transactions. To some degree, they are legally liable to do so on behalf of their clients. They have huge blocks of trades to execute, due to managing portfolios of billions or millions of dollars. If they execute at the current price, they usually will drop the price significantly lower, resulting in an unfavorable average price.
To get the best fill, these parties will use their massive capital to spike price and transact into the stop losses beyond the most recent high or low. This commonly happens on lower time frames, since it is easier to move price a short distance than a long distance. Thus, one-minute timeframes have more spikes than one hour, which has more spikes than daily timeframes.
To compensate for potential stop spikes, be aware that using stops which are very narrow to your entry may result in you suffering losses due to a “Stop Hunt”. To avoid a stop hunt, add distance onto the placement of your stop, and scale your trade size to the higher distance. Placing your stop loss right in the same location as hundreds of thousands of other traders will potentially result in being stop hunted.
Average True Range & Stop Hunting
A common practice is subtracting the average true range of the time period from the current price if buying or adding the average true range of the daily time period to the current price if selling. Widen the stop further by potentially using a multiple of Average True Range, such as 2 times or 3 times. For added safety, you can modify this rule. If buying, add the average true range onto the recent low. If selling, add the average true range onto the recent high. This adjusts the stop for the volatility of the time period selected, making it less likely you’ll be stop hunted, but not impossible. The higher the timeframe, the more likely adding the Average True Range onto your entry price will reduce your chances of suffering a stop hunt loss on a trade.
You can also use the Value at Risk, Expected Shortfall, or Expected Tail Return to create stops based on what has previously occurred at the 90%, 95%, or 99% worst return in the long or short direction. This prevents certain worst case scenarios but may allow more loss than needed using a multiple of Average True Range.
There is a tip for setting multiple stop loss orders, and it’s called “One Cancels Other”. This submission partners two orders, and if one triggers the other cancels. Use “One Cancels Other” to partner a fixed stop and a Trailing Stop. The fixed stop insures against an adverse asset movement at the beginning of a trade. A trailing stop locks in gains over time as the price trends profitably. Why have a separate fixed stop and trailing stop bridged together? The fixed stop can be placed closer to the asset’s purchase price and the trailing stop can be set at a larger distance. The wider trailing stop will allow the price to trend, retrace, and then continue moving in the profitable trend direction. It will still stop you out if the price moves too far against you while securing profits earned after passing the purchase price. Most price trends temporarily retrace previous movements before continuing the trend. The wider trailing stop can allow price fluctuation while the fixed stop closes you out if you’re initially wrong.
Most importantly, the one cancels another setup ensures against double stops placing you in undesired positions. Let’s assume you own 5 Crude Futures Contracts. If your fixed stop and trailing stop are separate, the trailing stop would trigger first, selling 5 Contracts and closing you out of the trade. Without the cancels other order, the fixed stop loss would remain in place, set to sell another 5 Contracts. If price fell to the fixed stop loss, that order would trigger, and you’d unexpectedly find yourself in a short sale for 5 Crude Futures Contracts. One cancels other prevents this issue.
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