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You have been told that a stop is a must for any trader, and many beginners follow this rule blindly without a true understanding of what it means. There are successful traders who will always, without fail, place a stop order for every trade initiated, while there are those who never follow this rule and still manage to make money in the markets.
What most traders need, but fail to understand is that the only time you should exit your position for a loss is when the initial conditions for entry have changed. It is that simple. So should we use stop orders or not?
When to Use Hard Stops
- When you are following a strict technical system. If you trade with a strict set of rules based on technical indicators, it will be very obvious when your indicators change direction. As most indicators are calculated based on price, there will be an exact price level at which the indicator tells you to get out.
- When you are unable to monitor the market. If you are carrying a position, but have no access to prices and are unable to place orders, you should always have a stop in place, even if it is very far from the current price. Leaving your position exposed can be very dangerous if an unexpected event occurs, and they always do.
When Not to Use Stops
- Some beginners like to place stop orders so that their position will be automatically liquidated if they are losing a certain amount of money. This is commonly referred to as a 'monetary stop', and if you are using it you should seriously re-consider your trading strategy. Understand that the market does not care how much you are making or losing. Where prices move to has no direct relationship to your profit and loss. What you need to ask yourself is, has the market moved to a level such that my initial view has been invalidated? If it has not, but you liquidate your position anyway just because you are uncomfortable with your losses, you are truly doing yourself a disservice.
- Personally, due to the fact that markets are inherently 'noisy', I find that it makes more sense to identify a range rather than an exact level, and in such cases, I would prefer to monitor the market and exit my position manually after carefully observing the price action. Be aware though, that handling your exits in this manner requires that you are fully aware of your reasons for entry and are very familiar with the market you are trading in.
In summary, all traders should understand that the use of stop orders is unique to each individual's overall trading strategy. In trading, as with the markets, there are no hard and fast rules; following some rule you have learned or read about without true understanding will only set you on the road to trading losses.
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