Stop-loss orders are used to protect profits and prevent excessive losses.
A basic stop order is an order which liquidates your position should the market turn against it. The stop order becomes a market order when, and if, the stop price equals the current market price.
In a bull (rising) market, the stop is placed BELOW the entry price. Bonds seem to be rising. You decide to buy the market at 9516. A stop could be placed at 9500, a risk of $500.
In a bear (falling) market, the stop is placed ABOVE the entry price. Bonds now may be falling and you're short one contract at 9516. You want some protection if the market reverses. A stop is placed at 9600, again a risk of $500.
There are different types of stop-loss orders such as the stop with limit (which uses two prices), stop close only (a disaster if the market opens against you, and continues against you throughout the day) and the stop limit close only (even more of a disaster for anyone with less experience than a professional trader).
WHERE to place the stop seems to be a question without an answer. If you use Elliott Waves, stops are placed several points above or below the start of Waves 1, 3 or 5. J. Welles Wilder, Jr.'s Volatility System (reviewed in July 1989 "Technical Analysis of Stocks & Commodities" magazine) places stops in relation to previous days' highs, lows and closes. For a newer trader, any method that allows the trader to limit risk to a comfortable amount of money is fine.
The type of stop used should be a simple stop order. No magic, no frills, just protection. Place your order and place your stop. If you are right, great! Your stop will not be hit. If you're wrong (and you will be!) and prices hit your stop, you're out with minimum, pre-determined losses.
Establishing stops has always been more of an art than a science. There are no universal rules that will cover setting stops for all markets in all market situations.
As one trader said, "The distance that a stop is placed away from the market is directly proportional to that trader's tolerance for stress, pain and monetary losses."
One way of locating stops is by using trendlines, which usually connect two or three non-consecutive lows (in a bull market), or highs (in a bear market).
Trendlines are used for establishing just that - market trends. Chart 17 is of the March 1984 S&P 500 Index. Five trendlines - A, B, C, D and E - have been drawn on the chart. When prices break the trendlines at points a, b, c, d and e, it indicates that the trend is changing, and some type of action should be considered by the trader.
Trendlines can also be used as a guide for estimating stop-loss prices. The stop is placed at the intersection of the trendline and the current market day. But there are two drawbacks to using trendlines for locating stops.
First, stops may be too far away from current market prices to offer reasonable protection points. Points Si and S2, marked with a "+" on trendlines B and E, are examples of this.
51 on Trendline B crosses 9/20/83 at 16873. The low for that day is 17205. This equals a risk of 332 points, or $1660.
52 on Trendline E crosses 1/10/84 at 16621. The low for that day is 16990. This is risking a whopping 369 points, or $1945.
If the market were to reverse suddenly, would you be happy losing that amount of capital from your account, or lost profits from your position?
Second, conventional trendlines are not responsive to the actual cyclic pulse of the market. Some profits will be given back before market prices "catch up" to trendline prices.
A way around this is to use Gann geometric angles to locate stops. Some of the benefits are:
1) Only one point, instead of 2 or 3, must be used.
2) The point from which the angle is drawn is close to the Retracement Zone.
3) Gann Angles have proven to be "market sensitive."
A lxl Gann Angle, for instance, will not intersect prices at the same level for all chart scales. However, the relationship between the 45-degree Gann geometric angle, being used as a stop-loss line, and the Retracement Zone angles will be the same.
This cannot be stressed enough. Your concern is THE PRICE RELATIONSHIP BETWEEN WHERE YOU ENTERED THE MARKET AND THE STOP-LOSS LINE, SUPPORTED BY OTHER INDICATORS. You are not looking to enter or exit the market always at a specific point, but at ANY point that will be profitable for you.
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