An old friend and experienced trader emailed us with his take on stops in regards to the previous post…
Include me in the negative opinion camp about using hard trading stops.
I believe that market makers and others will run stops when they can since it is instant liquidity for them. I think that their basic goal is increased trading volume with little significant price movement. In fact, when I recognize certain overall market conditions, I will use day entry limit orders setup to look like stops to take advantage of other traders running stops. This works well but triggers infrequently. This indicates that running stops doesn’t happen as often as some beginners may think it does.
I have run live trading tests on my discretionary trading using entered stops and mental stops; mental stops are far superior for me except when day trading technical patterns. I use stops on those kinds of day trades because I believe that in the very short run the market is essentially random. In those conditions, noise can often take me out incorrectly.
My mental stop method gives me more trading options at the price stop point. If a trader was wrong about the entry, it would be foolish to assume that the trader was 100% correct about the exit point. People understand that entries are a probabilistic thing and then quickly forget that so are exits. Beginners tend to exit way too early in my experience. Some of my best trades start off looking like the worst.
For beginners using hard stops now, my advice is that they are most likely trading positions much too large relative to their cash. Both of your proposed solutions (wider stops and lower position sizes) essentially say the same thing a different way. One of my principles is that every trade has a mix of luck and skill and in the long run the luck will cancel out. Therefore, I use almost no hard stops at all but almost always have lots of cash remaining.
One other issue for beginners is trying for perfection. Beginners seem to think that there is some secret system in the market that will bring them riches. Belief in magic systems helps to cause this hard stop issue. Traders are not perfect, so why would anyone assume that the market (made of up many traders) is perfect? One day one may wake up and say, “I was wrong about my stop price because I am not perfect, but hey, what a fantastic trade!” Or put another way, two wrongs can indeed make a right in the stock market! There is no magic!—Level7
