Employing Protective Stops to Manage Your Trades
There is no absolutely perfect money-management tool in futures trading, although purchasing options on futures does limit your risk of loss to the amount paid for the option. Purchasing options does have its disadvantages, however, and I won't go into that in this feature. What I will focus upon in this educational feature is the placement of protective stops (a sell stop if you are going long and a buy stop if you are going short) in futures trading. Protective stops are not a perfect money-management tool, but they are very effective in helping to solve one of the most important elements of futures trading: When to exit a position.
Before I discuss the advantages of using protective stops, I want to discuss a disadvantage about which many long-time traders are fully aware: Floor traders in the pits "gunning" for stops. This is a real phenomenon whereby "local" floor traders (those who trade for their own account) think they know where most of the resting buy or sell stops are located, and then attempt to push prices into those stops, set them off, and then let the corresponding price move run its course, only to then take profits on that move and the market price then returns to near levels seen before traders went gunning for the stops. This action by floor traders is not illegal or even unethical--it's just a part of futures trading. These floor traders have to pay a lot of money (or their sponsor pays their fees) to trade in the trading pits on the exchange floor. They do have some advantages over off-floor traders and, importantly, they also provide the needed market liquidity that all traders and hedgers appreciate.
Floor traders gunning for stops is more an art than science, as market conditions have to be just right for their efforts to pay off. For "local" floor traders to push a market in their desired direction, outside fundamental factors need to be about in equilibrium and not having an influence on market prices. For example, any floor traders gunning for sell stops just under the current market price won't get the job done if there were a bullish fundamental development that would pushes prices higher. Remember, no one group of traders--not even floor traders--can influence market prices very much or for very long.
Also, sometimes floor traders think they know where stops are located, and when they push a market and try to force a bigger price move, they do not find the stops and then they are forced to cover their trades at a loss.
A longtime friend of mine and former Chicago Board of Trade grain floor trader, John Kleist-now a highly respected grain and livestock market analyst--told me the following about locals gunning for stops: "Back in the 1970s and most of the 1980s were really the 'last hurrah' for locals wanting to gun stops. And it basically was in the 1990s when better (and more transparent) communication allowed important news to filter 'down' to the pits, rather than 'up' from the trading floor. Locals gunning for stops now is usually more effective in illiquid trading pits, such as the hogs or bellies--and less effective in soybeans and wheat, and very difficult in the corn pit. Gunning for stops has been replaced by locals coat-tailing the commodity funds and exaggerating price moves. Maybe that's the same effect but done a different way. Stops have to be relatively nearby current prices--i.e. support/resistance areas commonly used as 'public' stop areas, if the locals are to be effective. And, of course, if near major moving averages in the case of the funds."
Okay, on to the advantages of futures traders employing protective buy and sell stops. As I said above, the major advantage of using protective stops is that--before you initiate the trade--you have a pretty good idea of where you will be getting out of the trade if it's a loser. If your trade becomes a winner and profits begin to accrue, you may want to employ "trailing stops," whereby you adjust your protective stop to help you lock in a profit should the market turn against your position.
On specifically where to place your protective stop upon entering a trading position, one of the most popular and effective methods is to find a support or resistance area that is within your loss parameter for that particular trade. Here's an example: A trader decides to go long corn futures and he does not want to lose more than $250 per contract if the trade turns out to be a loser. He should try to find a technical support level that's around 5 cents below the present market price, and then place his sell stop just below that support level.
I generally use the above formula when I place my protective stops. However, I know that the local floor traders also know where it would be most logical for most traders to place their protective stops. So, I will "tweak" my stop placement a bit to reflect this. For example, if I decide to go long corn and there is a solid support level that is within my loss-tolerance parameter, I will set my protective sell stop maybe a couple cents below that support level. My thinking would be that most other traders would set their protective stops about a penny below that solid support, and if floor traders were going to gun for stops, then they may not be able to hit mine if it's a couple cents below the solid support level. The disadvantage to this theory is that your stop may be hit anyway, if there were a bunch of stop triggered above my own stop and pushed prices lower. Also, my losing trade would be about $100 or $150 steeper per contract than if I had not tweaked my stop.
Only rarely will I call my broker and change the position of a protective stop in a trade in which I'm "under water"--meaning it's a losing trade at the time. That would defeat the purpose of making your decision on how much of a loss you'll absorb BEFORE you make the trade and are in the heat of battle during a trade. Conversely, on winning trades that I have going, I may call my broker every day and tighten a protective stop, if the market is moving rapidly.