Always have a stop, and ideally a limit

When trading financial derivatives such as forex, CFDs should you always use a stop?

Short answer: Yes!

Long answer: Yes you should always have a stop in place – even if you think you really don’t need one.

Note that I’m only referring to financial derivatives such as forex and CFDs where you trade on margin. If you are trading or investing in instruments where you pay the full price up front (as you will usually do with shares) then this doesn’t apply to the same extent.

Leveraged price moves

A stop is very important with derivatives because when you are trading on margin any moves in the market price is magnified (often by huge multiples –1:400 leveraged forex – are you insane!). A move in the wrong direction can easily wipe you out – along with any other unrelated positions that you currently have open. In the worst case you could even end up owing your broker money – and that is not a good place to be.

Stops are for wimps!

If you talk to people or read the trading bulletin boards there is often a certain amount of bravado about trading without a stop. Some people seem to think that stops are for wimps or are irrelevant for the strategy they are using (“I don’t need a stop because if the market moves against me I manually close out the position in time”).

Emotional decision making

Some people may be disciplined enough to close out at a sensible price but most aren’t. When the numbers on your screen start moving against you it is all to tempting to think – “I’ll stay in a bit longer – the price might go in my favour again”. The chances are that it will just keep going against you making your loss bigger. If you have a stop then you remove your emotions from exiting at the right time.

You should decide your worst exit price when you place the trade when you are thinking more rationally. You of course always have the option to exit earlier if you realise you are wrong before you stop gets hit. Just whatever you do don’t start loosening your stop. Remember the reason you set it at that value in the first place.

My strategy doesn’t require stops

Some people (for our example we’ll call our trader ‘MrNoStop’) will argue that the strategy they are trading does not require stops. They talk about never leaving the screen when a trade is open. If something happens there are always at hand – and cool headed enough – to close that trade.

So what happens then if some huge incident occurs which has a massive impact on prices. For example an unprecedented terrorist attack. Imagine that due to the incident the internet grinds to a halt – as it did on 9/11.

Suddenly MrNoStop’s trading platform stops responding, his previously fast internet connection grinds to a slow trickle. Now MrNoStop can’t exit his trade using his computer. Never mind thinks MrNoStop – I’ll telephone my broker. I always have their number to hand.

MrNoStop calls the number. It is engaged. He keeps trying. Eventually the number rings but no one answers. What is going on? Well of course MrNoStop isn’t the only one affected by the internet outage – all the broker’s customers are affected and they are now phoning the company on mass to either find out what is going on or close their positions. If only MrNoStop had used a stop.

Even if his normal strategy didn’t need a stop he still should have used an ‘emergency contingency’ stop to prevent this kind of thing from happening. It could have saved him a lot of money.

It can be good to have a limit order in place

In the title for this post I mentioned that you should always have a limit as well. Why is this?

Well let’s go back to MrNoStop’s bad situation. It is entirely possible that the terrorist attack could have had a massive positive effect on MrNoStop’s position. The price could have spiked up and then headed back down whilst MrNoStop was unable to use the internet or get though on the phone. If he’d used a limit order as well for this trade then it is possible that he may have made it out with a profit.

Some caution suggested

Maybe I’ve convinced you that always having a stop and a limit order is a good idea.

Well I’ll give you some warnings as well. If your trading platform implements stops and limits as separate tickets from the main trade then you need to be very careful to make sure you know exactly what tickets you have open! Make sure that you don’t accidentally get into trades that you didn’t mean to. If you close your trade ticket then close any associated stops and limit orders as well. Ideally you should have a blotter listing all your open tickets permanently on screen. If you have enough monitors then using one of them for account information can be worthwhile.

If your trading platform implements the stops and limits as part of the same order (and automatically cancels the stop and limit when the trade is closed) then things are much easier. This is because you can’t end up with forgotten stops and limits that are waiting to trigger when you least expect them!