Position Trading #2: Stop Orders
Oct 3, 2011 at 9:44 am in Position Trading by
Let me start by getting one thing off my chest: I hate the term ‘stop-loss orders’ and much prefer the more generic term ‘stop orders’.
Stop orders are useful for stopping losses, no doubt, but that’s only half the story. As well as stopping losses, traders need to also run their profits, and stop orders can help you to lock in those profits* without crystallising them too soon by selling out prematurely.
* only strictly true if the stop order is guaranteed.
Are Stop Orders a Panacea?
No, of course they’re not, but I once thought they were. Many years ago I had read that traders should aim to ‘cut their losses’, so in a sense I thought that any stop-out was a good stop out. Imagine my delight when my over-tight stop orders stopped me out frequently. Cutting losses was good (I thought) so the more stop-outs I notched up, the merrier I was. Hopefully you can already see where this is going: a slow death by a thousand cuts – thanks to a small loss on every stop-out – is ultimately no better than instant death. You’re still dead!
With this cautionary tale, I’d still like to assert that the stop order is the most important tool in the armoury of every trader. And for me, stop orders incidentally provide a cure for my over-trading habit. You see, it costs me nothing to periodically revise my stop levels – always up, never down on a long position — and this task keeps me busy ‘doing something in the market’ as an alternative to unnecessary and costly buying and selling.
Stop Orders in Position Trading
In relation to position trading I sometimes use the phrase:
‘Buy like a Trader and Hold like and Investor’
The idea is to place a relatively tight stop initially, as a trader might, in order to stop out for a small loss if your judgement is wrong; then to let the stop widen before trailing it at a safe distance below the rising price – so as to lock in an increasing amount of profit while hopefully never having to stop out at all. Just like an investor, you might even collect some dividends along the way, even in a spread betting account.
The exception to the initial tight stop policy would be where you can take limited risk even in the absence of a stop order. For example: a minuscule 1-per-point bet on a 10p stock would risk only £10, so in this case the small position size renders a protective stop order unnecessary. In contrast, when betting £10-per-point on four-digit indices you’d be have to barking mad not to apply an initial stop order… unless your name just happens to be Buffett or Gates.
The idea of limiting your risk through prudent position sizing rather than (or as well as) by applying stop orders will be the subject of my next installment.
Tony Loton is a private trader and author of the book ‘Stop Orders’ published by Harriman House.