2Bull Forex Blog

If there is one area guaranteed to confuse many traders and lead to multiple opinions on the most appropriate approach, it is the subject of stop losses. The science and the art of placing stops is featured extensively in many trading books and guides, but the bottom line is that there is no right or wrong answer, simply the fact that stop losses must be used to limit potential downside exposure when trading. Traders should also be careful not to confuse stop losses with buy stops, which trigger an opening position rather than closing the trade.

It is very important not to package together the placing of stops with money management, as the two represent different strands of trading. Simply put, stops are there to protect profits and limit the potential downside at any time once a trade has been opened, and are part of an exit strategy for trades that are already open. Money management covers position sizing or amounts to be risked within each trade of a portfolio.

Within this potentially complex subject, there are many different types of stops, and it should be added that stops are never guaranteed unless that facility is offered by the broker for an additional charge. Nevertheless, their use is an essential part of any trading strategy. For the examples below share prices are used, but stop losses should also be used when trading CFDs in commodities, forex or indices.

The uses and abuses of stops

Much has been written about the placing of stops and how to avoid them being triggered without too much risk. This of course is the $64m question for most CFD traders and very often causes more consternation than any other aspect of the trading process.

The basic idea behind where to place a stop is by reference to the overall trend or trading range within which the share is moving. As to the actual level of the stop, it depends on several factors including the trader’s overall money management rules, the amount of leverage, the time frame, and crucially the underlying volatility of the share chosen. The stop should aim to be placed at a level which if triggered would confirm the trade was incorrect.

There is no point in trading a highly leveraged CFD account with routine 5% stops as eight losses in a row, which statistically can be expected every few hundred trades, would lead to a minimum 40% drawdown on the account.

Having said that, there is equally no point in attempting to reduce the risk too far by setting 1.5% or 2% stops in highly volatile stocks or takeover situations as each trade needs room to breathe, and stops this tight are likely to be triggered within the normal daily ebb and flow of price movements.

A good rule of thumb is that if you cannot see at least double the potential profit in a trade compared to where you expect to place your stop loss, that trade should be passed over. Indeed some CFD traders look for three times profits achieved against losses as a starting ratio. Consequently an approach like this can be very successful by winning just three or four times out of ten, and is the hallmark of many of the world’s leading traders.

Many losing traders look for an entry point or strategy that wins six or seven times out of ten, but this is very hard to achieve consistently. Although the feeling of winning regularly is certainly warm, the win/loss ratio here very often tends to be very poor as too many winners are taken quickly, so the correct use of initial and running stops placement is crucial.

Types of stops:

The basic maximum loss stop

The maximum loss stop is the starting point for most traders and is triggered when the share price hits a level below or above the opening price of the trade, depending on whether it is a long or short position. It can be measured in percentage points or actual money terms, but for these examples percentages are used. So if a CFD trader buys shares in British Telecom at 330p with a 2% stop loss, then the allowed loss is 6.6p and the position is closed if the bid or selling price falls to 323.4p or lower.

Note that no mention is made of how many shares are purchased or how much is being risked, as this is part of the client’s overall money management.

If the shares gap down below the stop either intra-day or at the open of trading the next day, the closing trade is triggered at the first price available in the market for that size, which is why stops are not guaranteed.

As to the percentage size of the stop to be chosen, that depends on several factors including the trader’s overall money management rules, amount of leverage, time frame and crucially the underlying volatility of the share chosen, which is very important.

Volatility stops and the ATR

Clearly, a percentage based stop is likely to be triggered more quickly in a highly volatile share and one of the ways traders can adjust stop levels is by ratio to the underlying volatility. There are various measures of volatility available, but a simple way is to use a stop related to a multiple of the average true range indicator, which is featured in most software packages.

The ATR determines a share’s volatility over a set period that can be defaulted as desired. The daily ATR indicator is very simple to calculate and is the highest of:

- The difference between the current high and the current low
- The difference between the current high and the previous close
- The difference between the current low and the previous close

Basically this is the maximum range in which the share has traded from the previous close to the current high and low. The average is then taken over a set number of days (ten is often used), and the stop is then calculated as a multiple of the ATR.

The reason this indicator is useful is that it becomes easier to place a stop outside the normal range of trading so that it is not hit by the short term random action of individual shares based on their average volatility.

As to the multiple of the ATR to be used, that is for the trader to decide, but longer term players and seasoned stockmarket investors tend to find a 2.7 to 3.3 multiple (which can equate to 5% to 15% stop losses) is applicable. Shorter term or highly leveraged players need to tighten the stop accordingly by adjusting this multiple.

The breakeven stop

This is a commonly used stop in which the trader closes the position if it reaches a minimum profit and then returns to even or back to a loss. So in the above example, if the price of BT rises say 2% to 336p, the stop is moved up to 330p, which was the opening price of the trade.

Please note that the breakeven stop here is not simply a new 2% stop loss – it’s very slightly different – but very often this approach is used as a rough and ready way to protect the downside. This leads on to the important subject of trailing stops.

Trailing stops

Trailing stops are widely used by professional traders as they provide an element of protection for winning positions without sacrificing too much of the profit.

The idea here is that once the position is opened, the trailing stop runs behind of the best profit achieved throughout the trade and the stop (whether percentage or price) is moved up accordingly.

There are three rules and suggestions (examples here are for long positions):

1. The stop can and must never be lowered

2. The percentage or price of the stop at each stage of the trade does not have to be the same. For example, the trader in the above example may begin with a 2% stop in BT, and then the share price might rise to 346.5p, which represents a 5% profit. At that point, the trader may wish to tighten the stop to 1%, so that a minimum 4% profit can be taken but with more potential upside. This approach is to the discretion of each player, but it is a very useful way of nailing down profits.

3. Another approach is to raise the stop loss with reference to recent action after a certain profit has been reached. Instead of a percentage stop, the trader might move the stop up behind daily lows, thus protecting against a potential trend change.

4. The stop might be triggered if there is a sudden rise in volatility with a reversal in the shares, and some traders use as a trigger if the day’s ATR is double the average ATR of the last ten days. This is very useful where a wider initial stop has been taken and there is the potential for a trend change before the trailing stop is hit, thus protecting the downside.

Finding a suitable indicator that reliably defines a trend is one of the keys to successful investing, whether it is on the stockmarket, in forex trading or commodities. CFD traders are often faced with a bewildering array of trend indicators on their software, and when searching for the elusive holy grail of the perfect indicator, the idea is not to miss a major move but also not being whipsawed too often. There is of course no straightforward indicator, but this paper looks at the less well known TEMA.

The basic moving average

Traders usually begin with a basic simple moving average, which is easy to plot, and here there is a trade off in terms of the amount of data used. Longer term investors tend to begin with the 200 day moving average which is something of a yardstick, and the trend rules are very simple. If the share price is above the 200 dma, and the average itself is rising, this suggests a long term bullish trend or a buy signal. The opposite scenario is often used for selling, and long positions are often closed out if one of the above conditions is breached, but each investor has there own methodology.

The obvious problem here is that such a long term indicator misses the first few months of a change in trend, and whilst this is not such a problem for very long term players, it can result in the giving back of a large chunk of profits at the end of a trend. The benefits though are that very few changes need to be made to a portfolio, and there is a much lower chance of a quick reversal in the trend, which can often last many years.

As the length of a moving average shortens, more signals are giving as the average responds quicker to trend changes, but there is also more whipsaw action. In trading range markets, which can often last far longer than trending conditions, moving averages are of little use.

A quick word on the MACD

One refinement to standard moving average analysis is to use crossovers as signals, and one formula derived from this is the MACD which can be used to identify turning points, the momentum and the trend of any stock or index. The most popular MACD formula starts by subtracting the 26 day exponential moving average from the 12 day exponential moving average.

Crossovers between the moving averages are often used to provide golden and dead cross signals, and that formula provides the basic MACD line and the initial signals to watch for. What then happens is that a 9-day exponential moving average of that line is taken, and this is called the signal line, which gives various useful signals.

MACD has become very popular in recent years, and because of this there are now many false breaks and chaotic action which make its success rate questionable at the very least.

There is though another smoothing indicator which has been tested by some technical analysts to give more precise trend change recommendations. Again it works better in trending markets, but it has uses in spotting turning points, and some analysis suggests that it is better than the MACD as an all round indicator.

TEMA – Triple exponential moving average

TEMA is not that old and was developed by Patrick Mulloy in the early 1990s.
His idea was to try and reduce the time (and profit) lag in moving averages as the moving average length increased, and his solution was a modified version of exponential smoothing but with less lagging.

TEMA is not simply a moving average of a moving average of a moving average, but it is a composite indicator using a single exponential moving average, a double exponential moving average, and a triple exponential moving average. As with any moving average based technique, the trader can use opening, closing, high or low prices, but usually closing process are chosen.

The TEMA formula

1. Establish a simple (exponential is better though) moving average (EMA1)
2. Calculate a double exponential (EMA2).
3. Calculate a triple exponential (EMA3).
4. TEMA equals: (three times (EMA1 minus EMA2) ) plus EMA3

As with all moving average based analysis, the longer the timeframe used, the less responsive the TEMA will be to trend changes, but it appears to work well in steady trending conditions and volatile stocks.

From experience TEMA can be defaulted reasonably well using 14 day or 21 day averages, and for a longer term trend indicator, a 70 day or 100 day TEMA might be appropriate. As with all indicators it is simply a matter of finding an approach that suits each individual trader.

It is possible to actually apply TEMA analysis to MACDs themselves, and some software systems include a custom indicator using this approach, but it is simply a question of trying it out.

After all, finding the underlying trend is just one out of many rules for successful trading.

The FTSE 100 index is used as the benchmark for measuring the strength of the UK stock market, and some commentators have argued it has a natural bias to outperform the wider FT All Share index, because it tends to promote to its ranks those stocks which are in the ascendancy and remove others that are falling away.

From time to time the index can appear to be affected by a high weighting given to one particular sector, and it could be argued that at present the mining sector (Anglo American, Antofagasta, BHP Billiton, Kazakhmys, Lonmin, Rio Tinto, Vedanta Resources and Xstrata) has undue influence. Stock market traders will recall the famous and dramatic year of 2000 when the FTSE 100 list contained such passing technology stars such as Energis, Bookham Technology, Arm Holdings, Freeserve, Baltimore and Psion – great memories!

Given the increasing use of tracker funds, it is important to look at where sector and stock monies are flowing, because these fund managers have to match whatever is in each benchmark index, so new entries and deletions are worth researching by CFD traders before they happen.

The purpose of this paper is not to discuss whether or not it is worth buying or selling a new constituent, as significant academic studies (with some conflicting results) have been made on this subject. It is more a summary of what changes to look for in assessing possible constituent moves, and there are various ways that the FTSE 100 list can be changed.

Quarterly reviews

This is the most common way for changes to be lagged. The committee that oversees the various FTSE indices meets quarterly on the Wednesday after the first Friday in March, June, September and December. Constituent changes are then implemented on the next trading day following the expiry of the LIFFE futures and options contracts, which normally takes place on the third Friday of the same month. The rankings of constituents by value are calculated using close of business prices on the day before the review, and companies must have a minimum trading record of 20 days at the review.

A company is promoted to the FTSE 100 index if it rises to 90th or above when the eligible securities are ranked by market value

It is relegated if it falls to 111th or below.

Where there are more companies qualify to be inserted in an index than those qualifying to be deleted, the current lowest ranking constituents are relegated to ensure there are always 100 companies in the index. If there are more qualifiers for relegation, the highest ranking companies that are not already in the index will be promoted to match the numbers.

The six highest ranking non-constituents of the FTSE 100 Index at the time of the periodic review are known as the reserve list, and are used in the event that one or more constituents are deleted from the FTSE 100 during the period up to the next quarterly review.

Fast Entry

The second way a company can enter the FTSE 100 index is if it is a new issue and larger than 1% of the full market capitalization of the FTSE All-Share Index. In this case it will normally be included in the top 100 after close on the first day of trading, and the lowest ranking constituent is removed.

Eligibility of equities

Only the eligible quoted equity capital is included in the calculation of its market capitalization, so if a company has two or more classes of equity, significant and liquid secondary lines are included in the calculation of the market capitalization of the company, based on the market price of that secondary line.

The committee can decide if a secondary line is to be priced separately if its full market capitalization (before the application of any investibility weightings) is more than 25% of the full market capitalization. If the full market capitalization of a secondary line, which is already a constituent of the Index, falls below 20% of the company’s main line at the quarterly review, the secondary line will be deleted from the index, but this happens rarely.

Convertible preference shares and loan stocks are excluded until converted.

Rights or other issues

If a company issues shares, partly or nil paid, and the call dates are already determined and known, the market capitalisation is adjusted so as to include all such calls, which would reflect the total fully shares in issue.

Mergers and takeovers

If a merger or takeover results in one constituent in the FTSE 100 index (or FTSE 250 for that matter) to be absorbed by another constituent, there is a vacancy in the appropriate index. The highest ranking security in the appropriate Reserve List as at the close of the index calculation two days prior to the deletion is chosen.

If a constituent company in the FTSE 100 or FTSE 250 is taken over by a non-constituent company, the original constituent will be removed and replaced by the highest ranking non-constituent on the appropriate Reserve List.

The company resulting from the takeover is however eligible to become the replacement company if it is ranked higher than any other company on the Reserve List.

Company splits or demergers

If a member of the index is split or demerged into two or more companies, the resulting companies are eligible for inclusion as index constituents in their own right. This is again based on each new company’s market capitalisation (before the application of any investibility weightings).

It may be that the lowest ranking FTSE 100 constituent gets relegated to the FTSE 250, so when GUS demerged into Home Retail and Experian last October, Party Gaming was unfortunately relegated.