Lesson 45: Mrs. B enters a stop/loss order
Our hypothetical Mrs. B is back in the market. She purchased a
Chicago May Wheat Futures Contract "at the market on the
close" on Wednesday, October 17th, 2001, when the Chicago May
Wheat Futures Contract closed at 290 ½. Mrs. B is now
hypothetically long one May wheat futures contract. Each one-cent
advance in the price of May wheat will mean a $50.00 increase in the
equity balance in Mrs. B's commodity account and each one-cent
decline in May wheat prices will decrease her equity by the same
$50.00. As she is back in the market, Mrs. B has two decisions
to make. She has to establish strategies for being taken out,
either with a loss or with a profit. Mrs. B always looks at the
loss side first. It is losses that she is primarily worried
about because losses may force her out of the game. She also
looks at the loss side first because she knows that losses are quite
common in commodity futures and options trading. At times
almost every commodity and options trader feels a little like a
Victor Hugo character, the man who lived "under the roof of the
falling tiles",
"At twenty-five he was bald. His father had died owning
a house and some land, but he, the son, had found nothing more urgent
than to lose this house and land in a bad speculation. He had
nothing left. He had considerable knowledge and wit, but he
always miscarried. Everything failed him, everything deceived
him; whatever he built up fell upon him. If he split wood, he
cut his finger. Every moment some misfortune happened to him; hence
his joviality. He said: 'I live under the roof of the
falling tiles'. Rarely astonished since he was always
expecting some accident, he took ill luck with serenity and smiled at
the vexations of destiny like one who hears a jest. He was poor, but
his fund of good-humor was inexhaustible. He soon reached his
last penny, but never his last burst of laughter. When he met
adversity, he saluted that acquaintance cordially. He patted
catastrophes on the back. He was so familiar with fatality as
to call it by a nick-name."
Mrs. B has less than $5,000.00 left in her hypothetical
commodity account and a string of ten $500 losses will mean that she
too lives under "the roof of the falling tiles" and will
have to call it quits. She doesn't want to call it quits; she
plans to make money from her investments. To do so, however,
she must make sure that she is not taken out by errors of
judgment. To reduce human error, Mrs. B has adopted this
rule: When I enter a position, I will initially risk $500.00 on
that trade. If my equity declines by $500.00, I will get out to
protect my account balance. Using this rule, with an initial
account balance of $5,000.00, I will not lose all my money until I
have a string of many losses in a row. Any profits I make will
extend my trading life. Even if I never make a profit, I will
have to suffer ten losses in a row to deplete my account
balance. If I make any profits, I will be able to remain a
trader for a longer period of time. Mrs. B believes that as
long as she can remain trading, she will, one day, have the
opportunity to make some profits. It is just that she has to be
sure that she is not taken out of the game by a series of ten losses
in a row.
Mrs. B is long May wheat at 290 ½. A stop/loss that would
result in a loss of approximately $500.00 would be placed at
281. This is only an estimate because actual losses are not
known until actual stops are hit in actual markets and actual fills
are made. There is to be considered, also, the commission that
Mrs. B will have to pay. It is also a near certainty that a
stop at 281 will not fill at 281 but will fill at a lower price
level. Then there is the wild card of limit moves and the
possibility that a market may move the limit and that Mrs. B will be
unable to have her sell order filled at the stop/loss price or at any
price within the day's trading range.
Mrs. B knows all this. She knows more. She knows that
markets often move to even numbers and then retrace their paths.
In the case of Chicago May Wheat, the 2002 contract, Mrs. B is
afraid that the market might move down to 280 (an even number) and
then return to a level above 300. It seems to her that if she
puts her stop/loss order at 281, she might be taken out should prices
decline to 280 and then miss the opportunity for profit should prices
thereafter advance above 300. Because of this, Mrs. B
rarely places a stop/loss order for a long position right above an
even number. She definitely never places a stop/loss order for
a long position at an even number. A stop for a long
position at 281 she would rarely do. A stop for a long position
at 280 she would never do. A stop for a long position at 279 ½,
she would do.
Entering her stop/loss order at 279 ½ rather than 281 increase
Mrs. B's risk on a single contract by about $75.00. She
believes, however, that while the dollar risk may be increased, the
probability of the stop being hit is lessened. While Mrs. B is
afraid that the market will decline to 281, she is less fearful that
it will decline to 279 ½. She is willing to suffer a
greater dollar loss should her stop be hit believing that it is less
likely that it will be hit. Using this form of reasoning, Mrs.
B calls her commodity broker and gives her the following stop/loss order,
"Sell l contract of Chicago May Wheat at $2.79 ½
/Stop - Open Order Good Until Changed or Cancelled"
Should this stop be hit, Mrs. B will suffer a loss greater than
$500.00. She understands this. Mrs. B, however, does not
plan to leave her stop/loss order at 279 ½ for very long.
Most likely she will leave it at that level for less than a
week. This is because of Mrs. B's additional rule, which reads
as follows,
An initial stop/loss order is just that, it is the "first
stop/loss order entered for any given trade". A trader
should always be prepared to change that stop/loss order once the
market moves in the trader's favor - or if events change and the
trader decides to risk less money on any given trade.
Mrs. B's initial stop/loss order is entered; it is at 279
½. Just as soon as she feels comfortable in moving it to a
higher level, she plans to do so, trying to reduce her risk to less
than $500.00 on this May wheat trade. As mentioned, she may
move it in less than a week. She may move it in 24-hours.
Mrs. B will watch May wheat to see where it closes each day and raise
her stop/loss as quickly as she feels comfortable in doing so.
Mrs. B hopes that she too doesn't live "under the roof of the
falling tiles". With a recently suffered $500.00 loss, she
doesn't want a second tile to drop with another $500.00 hit attached
to it. Thus, Mrs. B will do everything she can to reduce her
risk from $500.00 to a lesser amount as quickly as the markets allow
her to do so.
With her stop/loss firmly in place at 279 ½, Mrs. B now turns to
considering the possibility that her stop/loss order may never be hit
and that she might actually make a profit from this trade. Mrs.
B's second decision involves deciding where to place her
"profit/exit" order for her May 2002 Chicago Wheat
position. She will make this decision in the next lesson.
To order a copy of Bruce Gould's "Choppy Market Method" to
understand "Mrs. B's" reason for picking May Wheat Futures
at this time, at this price, click
here.
|
