Protective stops are intended to prevent excessive losses.
Protective Stops - what are they?
Normally, a protective stop is set to prevent a new trade losing more than the limit set by the trader. It is placed at a distance from the trade opening price such that if it is triggered, the amount lost will be the maximum the trader is prepared to risk.
The use of protective stops is standard practice among systems traders.
A trade is in its greatest state of uncertainty when it has just been opened. The trader is hoping to see it move in a profitable direction but it may not do so – the markets are unpredictable.
The rationale behind the protective stop is that it will call a halt to trades that are going in the opposite direction to the one desired. Allowance must be made to give the trade some room to move around but it must not be allowed to degenerate into a big loss.
Traders who use protective stops decide the largest loss they are prepared to tolerate and set protective stops at this level.
Use of the protective stop gives the trader some insurance, for which he must pay the price.
Some of the trades that trigger the protective stop will turn out to have been profitable trades – i.e. they will have ‘turned round’ and gone in the desired direction. However, they were curtailed by the protective stop and made into small losing trades.
The overall effect of employing a protective stop is to produce more but smaller losing trades and fewer winning trades.
In his evaluation of the system rules, the trader will have experienced the effects of all his rules – including the proposed protective stop. Therefore the consequences of the protective stop in cutting some would-have-been winners, has been taken into account.
Important aspects of the evaluation process are to determine the level of the protective stop and in the last resort, whether the proposed system rules are acceptable at all.
Copyright David Bromley 2006
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