Stops - Pros & Cons

Setting protective stops is an essential ingredient in any leveraged trading activity. This process can be done physically, by actually placing them in advance with your broker, or mentally, by deciding where a stop should be executed. Physically placing a stop may involve setting an alert with your software and watching the price action very closely. On the other hand, if you set the stop mentally, you may be focusing on one specific market and can immediately execute an order the moment the stop is reached.

The advantage of having the stop in the market is that it will be executed immediately, and there is no second-guessing. The disadvantage of a physical stop is that market makers and locals can see your stops and may try to "go" for them.

The disadvantage of placing a mental stop is that you may change your mind for the wrong reason when the price reaches that particular level. This action could be induced by your fear of taking a loss or your desire to give the price a little more room. For either reason, the change of mind is triggered under the duress of market action rather than objective thinking. Unless you are sure this will not happen and that you will stick to your guns, the mental stop approach is not advisable.

Whichever method you use, the important point is to make sure, when you enter a trade, you know exactly where you are going to get out if things go against you. As time progresses and prices change, the level of the stop is also altered. If you are trading more than one contract, or several hundred shares, there is no reason why you cannot split the stop at different price levels. After all, we are dealing with probabilities, and, if the probabilities are not so great, exposure should be less.

Why You Should Place Stops

There are several advantages to placing stops. First, by the very nature of establishing a stop level that is either physically or mentally entered, you are preparing yourself for the worst. In the case of profit-taking stops, it will be a mental preparation of an optimistic outcome. Quite often, when prices go against you, your emotions become clouded, making an objective decision harder to accomplish.

Placing the stop helps to overcome this problem because the decision to do so will be made when your mind is more equally balanced. If prices move sharply in your direction, it is often accompanied by good news, so good in fact, that it is easy to fall into the trap of believing that the price will continue to trend forever. That, unfortunately, is often the point when the price will reach an extreme.

Another advantage is that a correctly placed stop will usually get you out at a better price than just throwing in a market order. This is because a stop order is executed as a market order, once the stipulated price has been touched. If you are just watching the market and suddenly decide to stop yourself out, it is quite possible that the time delay will result in a far worse fill.

Where to Place Stops

With long positions, the best and most obvious point to place a sell stop is just below support, or to cover a short position above resistance. The terms support and resistance, in this sense, can mean a lot of things. Support, in reference to stops, for instance, may develop at a specified price level. Alternatively, it could be dynamic in the sense of a trendline or moving average acting as a support level. The key is to place a stop just below support, not at it. After all, if the price does not slip below a support level, or rise above a resistance level, the trend is not reconfirmed or reversed, depending on the circumstances.