Using stop losses

Protect your trading account

A stop loss is an order that automatically closes your trade at a specified price. They are used as a fail-safe mechanism to protect your trading capital in the event that the trade does not work out. Stop losses are therefore vital in protecting your trading capital, but there are different types of stop losses and a number of ways to determine where they should go.

Knowing where to place a stop loss order is not always clear. For example, you can use technical analysis to find levels of support and resistance, or you can place a stop loss based on nothing more than the amount of time for which your trade has been open. There is also a difference between a fixed stop loss and a moving stop loss.

This lesson will explain a number of methods of applying fixed stop losses, as well as some alternative types of stop losses that you can use when trading.

Fixed stop losses

A fixed stop loss is a stop loss that is placed without being adjusted during the trade. A trader will have to determine the best place for them to go at the time of entry.

Using swing highs and swing lows

If you enter into a trade, you can use the swing highs and lows to place your stop loss. These are logical places to put stop losses because they are the most recent prices at which the sellers and buyers were willing to sell and buy at respectively.

The following chart shows an example of a long trade where the stop loss has been placed under the most recent swing low:

If you enter a short position in a downtrend then you can use the most recent swing high to place your stop loss, as the following chart demonstrates:

Support and resistance

One of the most common methods for determining a stop loss placement is by using support and resistance.

Support and resistance indicate where buying and selling is likely to take place. In other words, you can see the highest price and the lowest price at which other traders are willing to buy or sell in the current market conditions.

For example, if you refer to the chart above, you will see that price is trading in a range with a clear resistance line, in which case you can look to enter into a short position. You can then place the stop loss just above the resistance level, because you know that this resistance level is the most recent price at which sellers are entering the market.

Determining where buying and selling is taking place by using support and resistance effectively allows you to place your stop loss in the safest place. If the price breaks through these levels and triggers your stop loss, then you know that current market conditions have changed – the buyers or sellers have not finished moving the price, and you can simply look for a new trade.

Using trend lines or channels

Another common method to place a stop loss is by using a trend line or a channel.

Once a channel has been established, it is unlikely the price will move outside, which means that you can use either the upper or lower boundaries to place your stop loss. If the price does break through the channel, then it is likely that the channel is breaking down and no longer valid.
One frequently used option to set the stop loss is outside of the upper or lower boundary of the channel.

The chart below demonstrates that after a channel had been established, one option is to place the stop loss just below the lower boundary:

Using moving averages

Moving average can also be used as support or resistance, in which case the best place to set a stop loss is on the other side of the moving average, much the same way that horizontal support and resistance or channels are used. In the following chart, you can see an example of a long entry where the stop loss has been placed underneath the moving average:

Trailing stops

Trailing stops are stop loss orders that follow a trade as it moves in favour of either your long or short position.

Some trading platforms have an option to set a trailing stop after the trade has gone a certain number of pips into profit. As the price moves in favour of the trade, a trailing stop loss will initialise and move in the same direction as the trade. This will reduce the risk as the trade goes on and eventually lock in profit.

As the trade must first go into profit before the trailing stop loss is initialised, a fixed stop loss must first be used when you enter the market.

Trailing stop losses can also be adjusted manually using indicators, such as moving averages, or trend lines and channels. 
For example, if you have entered into a buy trade as the price found support at the moving average, you can adjust the stop loss under the moving average as the trade develops. The following chart shows how you can adjust your stop loss up in the direction of the trade using a moving average:

How and when you decide to move the stop loss using the moving average is up to the trader. For example you can move the stop loss up in stages, as in the example above, or you can move your stop loss up each time a new candle appears and the moving average develops.

Time-based stop losses

A non-technical tool that can be used for placing a stop loss is the time-based method. The concept of this stop loss depends on how much time a trader is willing to hold a trade. A pre-determined amount of time is set and after that time has elapsed, the position is closed.

The reason why traders use a time-based stop loss is that if the markets do not seem to be moving in either direction and neither your stop loss nor the profit target has been hit, after a set period of time you can close down that trade in order to seek a better one for your trading capital. If the market price does not move significantly in either way, there would seem to be no advantage in keeping it open.

It is important to note that with trailing stops and time-based stop losses, money management rules still apply and should be used in conjunction with a pre-determined stop loss and profit target.

Guaranteed stop losses

There are some instances where the market price can gap between time periods — that is the opening price is different from the closing price. This can be common when the market closes and then opens the next day or after the weekend.

If you left your position open in the market during these closed times, there is a possibility that the price can move due to an event and "jump" over your stop loss. This produces a considerable risk to traders that leave open positions in overnight or over the weekend.

Although rare, some brokers will offer a guaranteed stop loss, which can protect you in instances where the market gaps over your stop loss. You may need to pay a premium on the spread to keep the position open over the market close, as well as meet the higher margin levels your broker would introduce.

Preparing For Contradictions

An important fact about investing is that there are no indisputable laws, nor is there one correct way to go about it. Furthermore, within the vast array of different investing styles and strategies, two opposite approaches may both be successful at the same time. 

One explanation for the appearance of contradictions in investing is that economics and finance are social (or soft) sciences. In a hard science, like physics or chemistry, there are precise measurements and well-defined laws that can be replicated and demonstrated time and time again in experiments. In a social science, it's impossible to "prove" anything. People can develop theories and models of how the economy works, but they can't put an economy into a lab and perform experiments on it. 

In fact, humans, the main subject of the study of the social sciences are unreliable and unpredictable by nature. Just as it is difficult for a psychologist to predict with 100% certainty how a single human mind will react to a particular circumstance, it is difficult for a financial analyst to predict with 100% certainty how the market (a large group of humans) will react to certain news about a company. Humans are emotional, and as much as we'd like to think we are rational, much of the time our actions prove otherwise. 

Economists, academics, research analysts, fund managers and individual investors often have different and even conflicting theories about why the market works the way it does. Keep in mind that these theories are really nothing more than opinions. Some opinions might be better thought out than others, but at the end of the day, they are still just opinions. 

Take the following example of how contradictions play out in the markets: 

Sally believes that the key to investing is to buy small companies that are poised to growat extremely high rates. Sally is therefore always watching for the newest, most cutting-edge technology, and typically invests in technology and biotech firms, which sometimes aren't even making a profit. Sally doesn't mind because these companies have huge potential. 

John isn't ready to go spending his hard-earned dollars on what he sees as an unproven concept. He likes to see firms that have a solid track record and he believes that the key to investing is to buy good companies that are selling at "cheap" prices. The ideal investment for John is a mature company that pays out a large dividend, which he feels has high-quality management that will continue to deliver excellent returns to shareholders year after year. 

So, which investor is superior? 

The answer is neither. Sally and John have totally different investing strategies, but there is no reason why they can't both be successful. There are plenty of stable companies out there for John, just as there are always entrepreneurs creating new companies that would attract Sally. The approaches we described here are those of the two most common investing strategies. In investing lingo, Sally is a growth investor and John is a value investor. 

Although these theories appear to contradict one another, each strategy has its merits and may have aspects that are suitable for certain investors. Your goal is to be informed enough to understand and analyze what you hear. Then you can decide which theories fit with your investing personality. 

Technical Analysis

Introduction
Technical analysis is the study of past price and activity history from charts in order to predict future price movements. The art of technical analysis is to identify patterns in price movements that will then dictate where that market is moving to in the future.

It must be remembered and more importantly understood that the market is not just a number of shares of different companies moving in one direction or another. The market is a number of human beings moving the price of those shares in one direction or another. People make the market change, when they demand more of one share or less of another. This is what moves the price. One may feel that a share price in an individual company has gone up because it has posted a large gain in profits that year. It hasn’t. The price of the share has gone up because based on that profit news more people wanted to buy that share. The human beings demanding that share have forced the price up. This concept is crucial to your understanding of technical analysis.

Human nature remains more or less constant and tends to react to similar situations in consistent ways. By studying the nature of previous market turning points, it is possible to identify certain patterns to develop an understanding of where the market is going to move in the future. Technical analysis therefore is based on the assumption that people will continue to make the same mistakes that they made in the past. Human relationships are extremely complex and never repeat in identical combinations. The markets, which as explained are a reflection of people in action, never duplicate their performance exactly, but the recurrence of similar characteristics is sufficient to enable market watchers to identify major junction, or turning points.


Philosophy/Rational behind technical analysis
There are three premises on which technical analysis is based:
1)History Repeats Itself
2)Prices Move In Trends
3)Market Action Discounts Everything

History repeats itself
Much of the body of technical analysis and the study of market action has to do with the study of human psychology. Chart patterns, for example, which have been identified and categorised over the past 100 years, reflect certain standard pictures that appear on price charts. These pictures reveal the bullish or bearish psychology of the market. Since these patterns have worked well in the past, it is assumed that they will continue to work well in the future.
Another way of expressing this premise is that the key to understanding the future lies in the study of the past, or that future is just a repetition of the past.

Prices move in trends

The concept of a trend is absolutely essential to the technical approach. Here again, unless one accepts the premise that markets do in fact trend, there is no point in reading any further. The whole purpose of charting the price action of a market is to identify trends in the early stages of their development and ride on that trend.

Furthermore, it is important to realise that a trend in motion is more likely to continue than reverse. A trend will continue until it changes course. This sounds a very obvious concept, but then this is what we are trying to achieve. We are looking for the most probable movement of a market. If the market is going up, it will continue going up until it reverses. If we can identify that market is going up, then we will buy the product until this identification tells us otherwise.

Market action discounts everything
This statement forms what is probably the cornerstone of technical analysis. Unless this premise is understood and accepted then nothing else really makes sense. The technical analyst believes that everything that could affect the price fundamental, political, psychological or otherwise is already reflected in the price of that product. It follows therefore, that analysing company’s profit forecasts is useless, as the market has already priced that into the value of the share. All that is needed therefore, is a study of the price action. While this claim appears at first hand to be rather fantastical and unbelievable, it is hard to disagree with if one takes time to consider its true meaning.

As a rule, chartists do not concern themselves with the reasons why prices rise or fall. Very often, in the early stages of a price trend or at critical turning points, no one seems to know exactly why a market is performing in a certain way. This doesn’t matter to a chartist, as he will just look to follow this trend. He knows there are reasons why the market has gone up or down, but he just doesn’t believe that knowing what those reasons are is necessary to the forecasting of that price.
It follows then that if everything that affects the market price is ultimately reflected in the market place, then all that is necessary is the study of the price action, not why it moved. By studying price charts and a host of other technical indicators, the chartist in effect lets the market tell him which way it is most likely to go.

Another very important thing that must be borne in mind when discussing technical analysis is that the practice of it is self-fulfilling. There are many millions of traders that treat technical analysis as a religion. When the chart pattern indicates they should buy, they will buy. If it indicates that they should sell, they will sell. If many millions are following the same pattern, the price will do exactly what they thought it would because they are all doing it. If everyone looked at a chart and decided at some point the market would go up. They would all buy it at this point. As they are all buying it at this point, the market will go up, as demand factors on that product will be greater than supply. There are a million technical analysts all buying at this level. We may as well join them.

What is the ’Best’ Time Frame to Trade?

Talking Points:

• Traders should look to utilize time frames based on their desired holding times and overall approach.
• New(er) traders should begin with a longer-term approach, and longer-term charts.
• Traders can look to move to shorter-term charts as experience, and success allows.

Regardless of how great a trader you ever become, you can always get better.

One of the most important aspects of a trader’s success is the approach being utilized to speculate in markets. Sometimes, certain approaches just don’t work for certain traders. Maybe its personality or risk characteristics; or perhaps the approach is just un-workable to begin with.

In this blog, we’re going to look at the three most common approaches to speculate in markets, along with tips for which time frames and tools can best serve traders utilizing those approaches. In each of these approaches, we’re going to suggest two time frames for traders to utilize based around the concept of Multiple Time Frame Analysis.

When using multiple time frame analysis, traders will look to use a longer-term chart to grade trends and investigate the general nature of the current technical setup; while utilizing a shorter-term chart to ‘trigger’ or enter positions in consideration of that longer-term setup. We looked at one of the more common entry triggers in the article, MACD as an Entry Trigger; but many others can be used since the longer-term chart is doing the bulk of the ‘big picture’ analysis.

The Long-Term Approach

Optimal Time Frames: Weekly, and Daily Chart

For some reason, many new traders do everything they can to avoid this approach. This is likely because new, uninformed traders think that a longer-term approach means it takes a lot longer to find profitability.

In most cases, this couldn’t be further from the truth.

By many accounts, trading with a shorter-term approach is quite a bit more difficult to do profitably, and it often takes traders considerably longer to develop their strategy to actually find profitability.

There are quite a few reasons for this, but the shorter the term, the less information that goes into each and every candlestick. Variability increases the shorter our outlooks get because we’re adding the limiting factor of time.

There aren’t many successful scalpers that don’t know what to do on the longer-term charts; and in many cases, day-traders are using the longer-term charts to plot their shorter-term strategies.

All new traders should begin with a long-term approach; only getting shorter-term as they see success with a longer-term strategy. This way, as the margin of error increases with shorter-term charts and more volatile information, the trader can dynamically make adjustments to risk and trade management.

Traders utilizing a longer-term approach can look to use the weekly chart to grade trends, and the daily chart to enter into positions.

Longer-Term approaches can look to the weekly chart for grading trends, and the daily chart for entries

Created with Marketscope/Trading Station II; prepared by James Stanley

After the trend has been determined on the weekly chart, traders can look to enter positions on the daily chart in a variety of ways. Many traders look to utilize price action for determining trends and/or entering positions, but indicators can absolutely be utilized here as well. As mentioned earlier, MACD is a common ‘trigger’ in these types of strategies and can certainly be utilized; with the trader looking for signals only taking place in the direction of the trend as determined on the weekly chart.

The ‘Swing-Trader’ Approach

Optimal Time Frames: Daily, and Four-Hour Charts

After a trader has gained comfort on the longer-term chart they can then look to move slightly shorter in their approach and desired holding times. This can introduce more variability into the trader’s approach, so risk and money management should absolutely be addressed before moving down to shorter time frames.

The Swing-Trader’s approach is a happy medium between a longer-term approach, and a shorter-term, scalping-like approach. One of the large benefits of swing-trading is that traders can get the benefits of both styles without necessarily taking on all of the down-sides.

Swing-Traders will often look at the chart throughout the day in an effort to take advantage of ‘big’ moves in the marketplace; and this affords them the benefit of not having to watch markets continuously while they’re trading. Once they find an opportunity or a setup that matches their criteria for triggering a position, they place the trade with a stop attached; and they then check back later to see the progress of the trade.

In between trades (or checking the chart), these traders can go about living their lives.

A large benefit of this approach is that the trader is still looking at charts often enough to seize opportunities as they exist; and this eliminates one of the down-sides of longer-term trading in which entries are generally placed on the daily chart.

For this approach, the daily chart is often used for determining trends or general market direction; and the four-hour chart is used for entering trades and placing positions.

The Swing-Trader can look at the daily chart for grading trends, and the four-hour chart for entries

Created with Marketscope/Trading Station II; prepared by James Stanley

We looked at an approach exactly like this in the article, The Four Hour Trader, centered on the daily and four-hour charts using price action as the predominant mannerism for entry.

But indicators can absolutely be used to trigger positions on the four-hour chart as well. MACD, Stochastics, and CCI are all popular options for this purpose.

The Short-Term Approach (Scalping or Day-Trading)

Optimal Time Frames: Hourly, 15 minutes, and 5 minutes

I saved the most difficult approach for last.

I’m not sure of exactly why, but when many traders come to markets – they think or feel like they have to ‘day-trade’ to do so profitably.

As mentioned earlier, this is probably the most difficult way of finding profitability; and for the new trader, so many factors of complexity are introduced that finding success as a scalper or day-trader can be daunting.

The scalper or day-trader is in the unenviable position of needing the move(s) with which they are speculating to take place very quickly; and trying to ‘force’ a market to make a move isn’t usually going to work out that well. The shorter-term approach also affords a smaller margin of error. Since less profit potential is generally available, tighter stops need to be utilized; meaning failure will generally happen quite a bit more often, or else the trader is opening themselves up to The Number One Mistake that Forex Traders Make.

To trade with a very short-term approach, it’s advisable for a trader to first get comfortable with a longer-term, and swing-trading approach before moving down to the very fast time frames. But, once a trader is comfortable there, it’s time to start building out the strategy.

Scalpers or day-traders can look to grade or evaluate trends on the hourly chart; and can then look for entry opportunities on the 5, or 15 minute time frames. The one minute time frame is also an option, but extreme caution should be used as the variability on the one-minute chart can be very random and difficult to work with. Once again, traders can use a variety of triggers to initiate positions once the trend has been determined, and we showed how to do this with MACD in the article, Scalping with MACD.

Scalpers can look to the hourly chart to grade trends, and the 5 or 15 minute charts for entries

Created with Marketscope/Trading Station II; prepared by James Stanley

Financial performance ratios – return on equity, capital and assets

A company's financial performance ratios will give you an idea of how efficient its management is at making the most of the capital and assets at hand.

Return on equity

A company's return on equity (ROE) helps you gauge its ability to turn money invested in it into profits.

ROE is calculated by dividing a company's net income by its total outstanding equity over that period and multiplying the figure by 100. It is presented as a percentage:

ROE = (Net income/outstanding equity) x 100

For example, a company that made a net profit of £5 million in its first quarter and had £100 million worth of shares outstanding over that period would have made a return on equity of 5% for that quarter.

If the company's ROE is low – even if it has posted record headline profit – it suggests that management is not reinvesting its earnings efficiently.

This could hinder the company's future growth prospects, making its shares less attractive and pushing down their price.

In theory therefore, the higher a company's ROE, the better investment opportunity its shares represent.

Do not take the ROE at face value

There are a number of factors, however, that can distort a company's ROE and these should be considered before you buy or sell shares based on the ratio.

For example, if a company buys back a lot of its shares, this will reduce the value of its outstanding equity and push up its ROE, creating a "buy" signal that might not be justified.

Return on capital employed

A company's return on capital employed (ROCE) is calculated by dividing its earnings before tax and interest (EBIT) by its total capital employed (both outstanding equities and debt). It is expressed as a percentage:

ROCE = (Earnings before tax and interest/total capital employed) x 100

It is similar to return on equity apart from the fact that debt is now added to a company's shareholder equity to reach a "total capital employed" figure. This makes it a slightly better measure of how well a company generates returns from its available capital.

A ROCE figure higher than average borrowing rate is desirable

As a rule of thumb, look for a ROCE that is equal to or higher than a company's average borrowing rate. This suggests that a company is a solid investment, and might encourage you to buy its shares.

A ROCE that is lower than a company's average borrowing rate could put downward pressure on its share price and on shareholder earnings.

For example, if a company has earnings (before tax and interest) of £800,000, debt liabilities of £200,000 and shareholder equity of £5 million (ie total capital employed of £5.2 million), it will have a ROCE of 15.4%.

If its cost of borrowing averages 7%, this company would make a good investment choice, based on its ROCE.

Return on assets

A company's return on assets (ROA) shows you how much money in earnings a company derives from each unit (£1, $1, €1 etc) of assets that it owns. This gives you an idea of how efficient the company is at turning what it owns into profit.

ROA is calculated by dividing a company's net income by its total assets and multiplying this figure by 100. It is expressed as a percentage:

Return on assets = (Net income/total assets) x 100

Different industries have different standards

A high ROA is generally preferable when you are looking for shares to buy.

Different industries tend to have widely differing ROAs, meaning it is not advisable to use this ratio to compare companies in different sectors.

Some industries are by nature more capital intensive than others – telecommunication providers, for example, will need lots of heavy equipment to turn a profit, while an advertising agency relies more on intangible assets like brand or intellectual property.

This means a poorly performing advertising agency could misleadingly appear a better investment based on its ROA than a well performing telecom company.

Compare companies within the same sector

It is best therefore to use this gauge to compare companies in the same sector.

For example, if auto maker A has a net income of £1 million and total assets of £10 million, its ROA would be 10%. If you compare this with auto maker B, its net income of £1 million and total assets of £20 million give it an ROA of 5%.

All things being equal, company A represents the best investment for a shares trader. This is because the company's management is doing a better job of doing what companies are all about – turning capital into profit.

You can also use it to look for performance trends at one company – examining its historical ROA and how it is changing. If it ROA is falling, this could encourage you to short its shares.

Master Your Trading Mindtraps

The popularization of speculative trading in the financial markets, partly due to the development of retail trading solutions offered on the internet, has created a new population of traders in the market. Most of these traders are non-professionals that are attracted by the potential to generate revenue quickly.

Falsely Created Expectations 

Many novice traders may believe that it is very easy to make money, especially when they are trying a broker service using a free practice account.

However, if these traders manage to generate a sudden substantial return, it can lead them to believe that trading is an easy occupation - one in which revenue can be quickly generated with little work by the trader. For the inexperienced, one good pick can make it seem like market speculation is the key to success and wealth.

Unfortunately, when these inexperienced speculators overtake this virtual investing environment and decide to start trading live accounts and risking real money on the market, the activity becomes much more complex. In many cases, the days of outstanding day-trading performance come to look suddenly and distressingly like old souvenirs - it is an abrupt initiation into the pitiless reality of the financial markets. 

Real Life vs. Practice

When new traders take the leap from their virtual trading accounts to trading with real money, they enter into the most difficult step of their initiation to trading: trading psychology.

In other words, while it may be easy to trade when the risk of loss does not exist, when the trader's hard-earned dollars are thrown into the mix, his or her focus and price objective can go out the window. Often, traders using virtual accounts will feel relatively comfortable even when the market moves against the positions they enter. This allows them to keep their focus on their price objective and wait for the market to get moving in the right direction. Because there is little consequence tied to "virtual money", personal emotion does not interfere. Unfortunately, when a trader's actions come to affect the gain or loss of his or her own personal assets, that trader is less likely to behave in such a methodical way.

Emotions Can Rule the Trade

Emotions can be seen as the trader's worst enemies; they often lead to misjudgment and loss.

Feelings generate what psychologist Roland Barach calls "mindtraps" in his book, "Mindtraps: Unlocking the Key to Investment Success" (1988). Roland Barach provides a collection of 88 lessons explaining the pitfalls, such as fear and greed, that hold many traders back.

Greed

Greed can lead a trader to hold on to a position too long in hopes of a higher price, even as it falls. This emotion has been the main reason behind many trades that have gone from large gains to large losses. To thwart this emotion, try to take an objective look at the reasoning behind your positions. When one of your positions experiences a large run-up, ask yourself whether the reasons behind your initial investment still remain; if not, it may be time to close or reduce the position.

Fear

Fear can prevent a trader from entering trades and lead to taking them out of positions far too early. If an investor is too concerned with potential loss and the risks that come with an investment, he or she can often be dissuaded from a good opportunity. Also, if a trader is more susceptible to fear, he or she may sell out of an investment far too early based on the fear of losing the gain he/she has made. In many cases, this can prevent a trader from cashing in on a much bigger gain.

Paralyze by Analyze

Paralyze by analyze is an interesting phenomenon in which traders get so caught up in analyzing everything about a potential investment, they never actually pull the trigger on the trade. In this case, what often happens is that the investor will constantly question all of the little details found in the analysis in an attempt to perfectly analyze a situation. This is a truly unachievable task, which can prevent a trader both from making monetary gains and from making experiential gains by getting into the trade.

A wide range of other emotions can rule a trader, but the important thing for any market participant is to recognize these emotions.

Acknowledge Your Emotions

All traders will experience at least one mindtrap, but the very best traders learn to recognize, understand and neutralize them. This process forms the foundation of any trader's training. Therefore, if you want to become a successful trader, you should first spend some time getting to know yourself and the particular mindtraps you tend to fall into. A skillful trader tends to have a strong desire to master his or her emotions and prevent them from affecting his or her performance.

Trading Nirvana

Traders are only human and, as such, perfection may not exist in trading. However, profitable trading can be achieved when a trader learns to manage his or her emotions. This will be easier for some than for others, but it is only through experience in the market that this skill can be developed. Therefore, before you can learn how to win, you have to take some risks (or at least get into the market) and learn to master the emotions that making (and sometimes losing) money stirs up.