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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.

 

            Bruce Gould

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.

Proceed to lesson 46 by clicking here.

 

Always remember that stock, options, and futures trading may involve substantial risks and that past performance is no guarantee of future performance.