Choosing an Optimal Stop Loss

One of the most frustrating occurrences for a futures trader, or any trader for that matter, is getting stopped out on a high print when short or the lowest price of a move when long. Choosing a stop loss price is a difficult task, but it is imperative after entering a trade. Stops are often placed just below a support area if a bullish bet is made and just above a resistance level if a short position has been taken. Some stops are set at the price that is the maximum risk one is willing to take on a trade. In volatile markets, stops are often triggered because they were set too tight. Balancing the amount of risk either in a dollar figure or a pivotal price can be daunting.

One way to decrease the pressure of choosing the optimal stop loss is to use options. Options can give us a bit more leeway to remain in the trade when event risk rises, making price swings become larger and unpredictable. Hedging a position using options is also known as a synthetic.

If a long position is taken and the trader wants to hold the position overnight, buying a put may be used in lieu of a stop below the market. This is called a synthetic call. On the other hand, a short position can be hedged by buying a put as protection against an unexpected rise in price. This is a synthetic put.

When riding a trend, using synthetics is a great way to remain in a position when a volatile session is likely. Interest rate futures and ETFs (TLT, IEI) are typically volatile when employment or inflation reports are released. Using options to define the risk of a stock during earnings can help hold the position. Grains are most sensitive to the monthly supply and demand reports. Currencies tend to be quite volatile when central banks reveal monetary policy changes. Fundamentals move markets, so be sure to check the calendar for critical moments.

As a trader it is imperative to track event risk. Under normal conditions, regular stops are usually best. But when an impact report is due, using synthetics should help weather a temporary jump in volatility and reduce the risk of getting stopped out during a period of panic.

John Seguin, Market Taker Mentoring

Trader Education