Although risk management is associated with quantitative measures, one primary way a trader can effectively manage risk has nothing to do with calculations. It has to do with executing your plan and getting out of a trade if you need to exit it. That means the top risk management tool must be in place-in particular, the stop order.
No amount of reading, testing, researching, paper trading or alms giving will matter without proper execution of your plan. Once you develop the right habits as a trader, you can fine tune things, including what methods you use to determine a stop level. To develop those good trading habits you need to understand the benefits and downsides to different order types. When in doubt, confirm order mechanics prior to placing it.
Order Entry
Regardless of the analytical features you use along the way, the most important tools available to the trader are order entry tools. In addition to those that reside on an exchange (the limit order or stop order) traders also have access to those that reside off the exchange (conditional orders) that trigger a more traditional exchange order.
Traditional Order Types to Manage Risk
The main consideration for a traditional order is whether it will guarantee execution (market order) or price (limit order). If the markets are going against you and you know you must exit a position, the only thing that will get the job done is a market order. You might not like the price for the execution, but your primary objective will be accomplished. In addition to the commonly understood market and limit orders, there are two types of stops orders:
- Stop Order: A stop order is one that triggers a market order once the trader identified stop level is reached. It's as if the trader is sitting in front of the computer, monitoring all trades and quotes for the underlying, ready to send a market order once the pre-determined price appears. In some instances, stop orders are only eligible for the day rather than good-til-cancelled [GTC], requiring trade entry each day prior to the market open. Option traders also need to be aware that the triggers for option stop orders are different than stock orders due to reduced trading volumes.
- Stop Limit Order: A stop order is one that triggers the trader's limit order once the identified stop level is reached. This requires some very specific price action for the underlying. The trader is dictating an exit if the position goes against them, but not too much. It seems the more a position is losing, the more urgently a trader would want to exit it rather than postpone it.
I personal have enough trouble guessing short-term market direction, let alone the specific action associated with a stop limit order. The only practical applications I can see for this type of order is for trade entry when you want to be sure you don't enter the position at any cost or for trade exit when there is the potential for commissions to exceed the sale price of the security (i.e. options near expiration).
Orders Residing off the Exchange
Traders may also have access to order types that allow them to identify price action to trigger a traditional exchange order. These types of orders are often referred to as contingent or conditional orders. Some act similar to an exchange stop order or stop limit order, while others provide more flexibility by tracking price action to protect profits (trailing stop).
Traders may also have access to a system that allows them to place orders on either side of the price action so they can exit for a profit or a loss. Such orders are referred to as one cancels other. Once one order is triggered, the other is cancelled so the trader does not end up with both trades executed.
Finally, traders can set a price alert to be notified when certain price criteria for the underlying or an index is met so they can take action. In all cases you must take the time to understand every aspect of the orders you plan to use.
Determining Stop Levels
Two primary types of stops used by traders include the dollar stop and the technical stop. Each is explained here and likely in any Optionetics or ProfitStrategies literature you have.
- A dollar stop uses a specific max risk value to determine an exit price. Assume a trader allows a position size of up to 5% of the account value and a maximum risk of 15% of the trade size, the total position risk is calculated as 0.75% of the account (5% x 15%). A 100 share position in a $50 stock is being considered ($5,000) and the trader would then allow a risk of $750 ($5,000 x 15%).
Using the max risk of $750 and dividing by the number of shares purchased gives you the per share dollar stop loss level. This number is then subtracted from the purchase price to obtain the stop. In the example, $750 / 100 shares = $7.50 per share; $50 - 7.50 = $42.50.
- A technical stop uses a trader identified technical value to trigger an exit. Since the stop level is identified first, this value is used to determine the appropriate number of shares to purchase. In this example, a little bit of a cushion is used with the technical value since price must violate the technical level rather than simply reaching it.
Using a technical level of $31.35 and a cushion of $0.08 for the technical level, a technical stop of $31.27 is identified. Given a current stock price of $33.40, this stop level represents $2.13 risk per share. Assuming the trader has identified a maximum risk of $750 per trade, the trader can purchase 350 shares and remain within their risk parameters.
So once a technical support/resistance level is identified, the trade backs into the number of shares purchased using the current price of the stock. To summarize, the trader subtracts the technical stop price from the current price to determine the dollars at risk per share. The trader's max risk is then divided by the per share risk to obtain the appropriate number of shares to purchase.
When calculating a specific stop value, you may want to allow for a little extra cushion that will allow a technical level or round number to be slightly pierced. Let's say your dollar stop approach gives you a value of $50 for the stop. It's believed this nice round number will attract price a bit and be tested as price moves towards it. By using a stop slightly below this level for a long holding, say $49.88, there is a little leeway in the event the $50 level ultimately holds. Just be sure you are still reasonably satisfying your risk parameters.
Similarly, a technical stop may be one that is widely followed, for instance a 200-day moving average. Assuming you know the value that would result in the moving average being broken, you can add/subtract a small percent in addition to the technical stop to allow for that value to be pierced slightly, but ultimately hold.
Practical Considerations
Traders who use technicals based on daily or weekly closes need to decide in advance how to manage price triggers that can potentially occur during the day or week. If you are unable to monitor conditions when the market is open, then there are not a lot of options - you may only be able to provide a pre-determined cushion in your stop order to allow for some intra-day or intra-week movement. In other words, a physical stop is required.
If you are able to monitor conditions and have the discipline to execute an exit once a specific price target is reached, you then need to decide what type of intra-day or intra-week movement is allowed and which type will result in an alternate exit. You would then be using a mental stop which is triggered via price alerts or an end of day review. For instance, a trader using weekly closes to determine a stop level has a dilemma if that price is reached on a Tuesday. Should the trader exit the next morning or wait to see what happens on Friday when the week closes?
The testing process should bring such situations to light - if not the trader will be faced with it sooner or later. As with other aspects of trading, it's best to decide how to manage this prior to creating the position. In the example provided, the exit rules may include exiting the position the following trading day if the week closes at or beyond the stop level or if there are two daily closes during the week that are at or beyond the stop level.
Risk That Remains
Remember that risk in the form of price gaps and trading halts remain even with disciplined use of stop orders. So unfortunately the true risk in a trade lies somewhere between the pre-determined exit and the max risk. Using stops will keep most of your trades closer to the former than latter.
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Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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