Stops…Damned If You Do, Destroyed If You Don't!

By: Leslie Burton

Trading in commodity futures can be a very challenging plight and the risk plan may mean the difference between a long-term trading life and a short-term trading life. Of course, there are traders that simply do not believe in stops and swear that the other brokers and/or traders are gunning for their stops.

First off, a stop may be a protective stop to offset a long or short position to limit the losses if the market moves against you. You may also use a stop to enter a market as channel breakout traders may want to buy and go long if a market breaks through support or sell a market if the market breaks through support. Buy stops are placed above the current market price and Sell stops are placed below the current market price. A stop order turns into a market order when your price is elected. In a liquid market, it may be at or close to your price. If you are in an illiquid market, the stop may be elected, but your fill price may be further away from your price depending on the market activity. A “static stop” remains fixed on a position until executed. A trader must remember, if offsetting the trade manually, to cancel the stop. A “trailing stop” may be used to lock in and protect profits as well. It may be set to follow your position by a certain number of points or ticks to move the stop up or down with the market. This may be done manually or by a bracket automatically. There may be conditions such as a limit moves whereby the market may be moving too fast and may pass through your stop price without triggering in creating more of a potential loss than anticipated. The term "limit up" and /or "limit down" is the amount of points, ticks or cents that a market may move within one session. The Daily Limits are set by the exchange to control the volatility until the market returns to a more stable state.

There are traders that will not use a stop loss or will simply use a "mental stop". Those traders may typically have a higher risk tolerance and they may have a trading plan that does not allow them to exit a position prematurely. Scaled traders may fall under this category as they may for example use a $100,000 account size with margins that will not exceed one-third of the account size. Scaled traders are buy and hold traders that may accumulate trades anticipating a longer-term trend. Position traders or longer-term, buy and hold traders may employ "emergency" or "catastrophe" stops. Each trader may construct a trading plan according to their trading goals and risk parameters, then it is just a matter of following the plan. To plan the trade and/or trade the plan, it takes time and practice testing strategies, indicators, time changes to cover every conceivable factor that may affect the trade. Traders may purchase these tools which come with user guides already mapped out or they experiment themselves for years sometimes to construct the plan. Many traders will use mental stops to stay with their intended positions during some of the retracements. This requires the trader to remain vigilant in monitoring the position. This is not advisable for a new trader. For a new trader to remain a trader, it is important to really remain disciplined in the risk management. Large losses may occur when using mental stops and/or none at all. Some traders may let a new position run initially until it becomes somewhat profitable and then place a breakeven stop. This method may keep a trader from getting stopped out on the initial entry and limits the offset to the entry leaving the risk to the commissions, fees and any differential from the election of the stop. Many traders may keep their static stops outside the channel of the market, the daily highs and lows or the hourly highs and lows depending on the trading plan. The ranges used to place the stops should be within the risk tolerance of the trader. Some traders may use a percentage of the account to calculate their potential risk on each trade. When doing so, it may be advisable to reflect on the chart as well to be sure that the stops coincide with the anticipated moves of the market. A gap move for example may give a stop level inconsistent with the percentage method. Time based stops may be used but may be difficult to use garnishing points or ticks.

When mapping out a trading plan, a trader would be well-advised to take a worse-case scenario and work from that perspective. Once the risk is comfortable, everything going forward is a bonus. When initiating a trade, the risk is the first area to look at. When accepting the risk, the trade itself becomes valid.

The Globex exchange has gone to price banding in their orders. Market orders and stops at the CME are initiated as a "Market With Protection" order. This allows the order to be filled within the pre-defined range. The Protected Range may be the bid/offer, plus/minus 50 % of the "no bust range" for that market. If that market order may not be filled as such, the unfilled order or portion of orders results in a Limit Order at the limit of the protected range. If the stop order is not filled, the order or portion of the order not filled will become a limit order at the stop level plus/minus the protection points. In the ICE exchange, the orders are similar. The stop orders with protection are entered as a limit order depending on the stop price plus/minus 100 % of the pre-assigned No Cancellation Range (NCR) level. The Metals on the NYSE-Liffe US uses dynamic price limits to limit any potential errors of orders based on trade price and/or bid/offer. The major difference between the CME/ ICE orders that execute a limit off the entered stop price, are that the limits are based on the beginning of the market move. Each commodity may have pre-defined dynamic price limits that can reject the orders out of the limit.

STOP ORDERS DO NOT NECESSARILY LIMIT YOUR LOSS TO THE STOP PRICE BECAUSE STOP ORDERS, IF THE PRICE IS HIT, BECOME MARKET ORDERS AND, DEPENDING ON MARKET CONDITIONS, THE ACTUAL FILL PRICE CAN BE DIFFERENT FROM THE STOP PRICE. IF A MARKET REACHED ITS DAILY PRICE FLUCTUATION LIMIT, A "LIMIT MOVE", IT MAY BE IMPOSSIBLE TO EXECUTE A STOP LOSS ORDER.

There are traders that seem to buy the high range of the day and sell the low range of the day. In their interpretation of the chart reading, they may define the channel but simply react inversely to it. Indicators such as a Parabolic SAR which is a stop and reverse indicator may help as a tool to react to the channel according to the indicator itself.

There are sophisticated traders that may study the correlation between markets to take advantage of these correlations. Perhaps instead of using a stop, a trader may have a Gold position and simply add a US Dollar which normally may trade inverse to Gold. The mix of varied markets may combine to create a portfolio that may trade automatically according to preset calculations. The CRB had been a mix of markets that had traded years ago often used to determine the moves of individual markets.

As we have discussed, there are many uses of stops and many ways to trade, but ultimately it is advisable for the majority of traders to use stops for protection. Emphasis should be placed on the trading plan and the mindset and discipline to follow the trading plan. The risk portion of the trading plan is the most vital aspect of trading. The unprepared trader may panic and simply react to the market impulsively. Many traders may chase the market to attempt an entry based on the excitement of the market move. Many traders will try to make back their losses ultimately losing more money. Many traders will simply look at the fundamentals thinking that the market must react a certain way eventually. We advocate the creation of a tried and true trading plan and controlled risk.

Plan the Trade, Trade the Plan.

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STOP ORDERS DO NOT NECESSARILY LIMIT YOUR LOSS TO THE STOP PRICE BECAUSE STOP ORDERS, IF THE PRICE IS HIT, BECOME MARKET ORDERS AND, DEPENDING ON MARKET CONDITIONS, THE ACTUAL FILL PRICE CAN BE DIFFERENT FROM THE STOP PRICE. IF A MARKET REACHED ITS DAILY PRICE FLUCTUATION LIMIT, A "LIMIT MOVE", IT MAY BE IMPOSSIBLE TO EXECUTE A STOP LOSS ORDER.

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