Retail traders should value stops regardless of the outcome..
A large number of traders, be it in equities, commodities, FX or any other trading instrument generally have the tendency to initiate trades without pre- defined targets and stops. A majority of those who have a defined strategy fail to staunchly follow them as trading psychology comes into play and everything else takes a backseat. Even in the case of traders who initially start by following pre- set trading parameters but unfortunately lose a few trades due to unexpected volatility for a number of reasons, tend to get nervous and eventually the fear of losses takes over and drives them to exit profitable trades early and hold on to losing ones in anticipation of a price reversal.
Before we head into the importance of stops, let’s briefly understand the various categories of traders-
- Manual or conventional traders- Typically comprise of individuals who enjoy making a quick buck by implementing day trading or scalping techniques and positional traders who hold on to trades for a slightly longer duration.
- Algorithmic traders- Execute pre- defined programmed strategies using various trading tools and mechanically place trades on the broker’s terminal. These system based traders generally do not monitor prices constantly and intervene only in the event of a system failure or if the strategy is not as effective as planned.
Regardless of the category of traders, market environment is unpredictable most of the time, even to the most successful. The smartest traders however ensure their downside risk on every strategy is secure although the extent will vary depending on the strategy, time frame, volatility of the underlying, risk- reward ratio, position size and so on. Just as traders vary to the extent of risk they are willing to take on their positions, there are also a number of ways to use stops besides the traditional ones. Traders can also look at stop limits besides cover and bracket orders to protect their downside risk. While the key purpose of placing stops is to protect investment risk and prevent capital erosion in the event of adverse price movements, they can also be a hindrance during volatile markets as they tend to be triggered pretty often. Traders defining stop orders should be aware of the market risk, volatility, key supports/ resistances and breakout levels and place them accordingly instead of using them only as a tool to preserve capital.
Looking at the trend of a company’s stock, the broader index, commodities or FX pairs, the key criteria is prices do not move in a straight line, no exceptions. There are only three events in the life cycle of a trading instrument; bullish, bearish and sideways, which is more than enough for a majority of traders to handle. All said and done, the benefits of having stops far outnumber the negatives, leading to disciplined trading activity over a period of time, sidestepping some of the most common trading blunders. However, every time traders disregard stops, their downside is undeniably vulnerable and can be typically characterized by a goalpost without a goalie.
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