A stop is the chosen price to get out of a losing trade, and stops are arguably the most important component of any trading system. In TV shows about Coast Guard rescue helicopters, they stress the crucial factor of reaching “bingo fuel”, which is the amount of fuel needed to get home safely from a flight. Once bingo fuel is reached, they must leave for home no matter what.
The same idea can be applied to placing a trade. If we set a bingo stop in advance and stick to it, we have a much greater chance of putting the odds in our favor over the long run. If we use the same urgency as the helicopter crew uses for their fuel as we use for our money “fuel”, we can venture out into trades and have more confidence in returning our money home safely.
Trading coach Van Tharp did extensive mathematical studies on money management and setting stops. His book, Trade Your Way to Financial Freedom, is a must read for all traders. He shows a system in his book that made money by investing with a coin flip on whether to go long or short. By using carefully planned trailing stops, it was a consistent winner averaged over time. Trailing stops that rise with the price are a professional tactic that anyone can use.
Stops can be set various ways. Some use a set percent of the price. For example, losing not more than 5% is a good start. If the trade or investment loses 5%, just get out. Using the Average True Range (ATR) indicator offered on most charting systems can be more suited to the trader for setting stops. This is explored and explained in Van Tharp’s book.
Trailing stops are available at most brokerages. This is a type of stop that allows you to automatically raise your stop as the price rises. These can be set as a fixed percentage of the highest price as it goes up, or a fixed dollar amount below the rising price.
Contingent stops can be useful in some situations. The trader can put in an order with the broker to stop out of a trade if certain market conditions are met. For example if we buy shares of a gold miner, we can put in an order to sell if the price of GLD goes below a set level.
Stops can be set to sell at a limit price or better. This can be risky since no stock might be on offer at that price when needed, while price continues to fall. Alternatively stops can be set to sell at the market, so you can get out at whatever price is currently asked.
Some traders prefer to set price alarms and put in their stop orders manually when their stop price is hit. This hides your intentions from the market and may help prevent sharp moves caused by large amounts of stops being triggered at once. It does add a level of risk that price continues to fall below your intended sell stop level.
Back in the old times before the internet, commissions were a big factor in trading. Broker commissions getting in and out of the trade ate up a large percentage of any potential profits. Many brokers were charging 2 percent of the trade amount or more. That is 2% to get in and another 2% to get out. Awful.
Today you can trade with online brokers for 5 or 6 dollars per trade. That makes commission costs almost negligible, which allows us to use tighter stops with less risk.
We can get in and out more often, which makes it more worthwhile to be nimble and not hold on to losing trades out of hope.
Here at 12 Points Gold, we set out to provide information to help keep the trader and investor in the market for upswings and out during down drafts. Our signals are designed to help you to identify the strong markets, and the weak markets when formulating your own trading strategies.
There will always be false signals and bad trades. By mastering the optimal use of stops, the traders and investors put the odds firmly in their favor.