Stop Running – And What You Can Do About It

One of the most common email questions I receive at www.YourTradingCoach.com is on the topic of stop running. Sometimes the question comes as a result of the trader having been stopped out on too many occasions by just a tick or two, leaving them to watch from the sidelines while the market then moves in their expected direction. Often these claims of stop running relate to post-economic news releases, as dramatic increases in volatility cause stops to be taken out on both sides of the market, prior to price settling into it’s preferred direction. Other times the question comes simply because the trader is new to trading and has read of stop hunting claims in one of the many forums, and is seeking some confirmation as to whether or not this is a real feature of the markets.

In putting together this article, I have taken excerpts from a number of my email replies. You will notice the article content relates mostly to forex brokers and the forex market. This is simply due to the majority of stop-running questions coming from forex traders – not surprising due to the decentralized nature of the forex marketplace. The general concepts though can be applied to any market.

All discussion relates as well to liquid markets. If you’re going to trade a very illiquid market such as some exotic foreign cross, penny stocks, or a long-dated options contract with a strike price far from the current market price, then all bets are off. You’re asking for significant slippage and much easier market manipulation. So, stick to highly liquid markets only.

A short disclaimer though – I have never worked as a broker, don’t know any personally and have never asked this question of a broker. My thoughts though, are as follows…

In answering this question, it’s important that we first gain a good understanding of how brokers work in the forex world. A quick way to do so is via the following link. The relevant material is in the first seven posts – there’s no need to read beyond that.

http://www.forexfactory.com/showthread.php?t=7484

This is a really good forum post (you’ll rarely hear me say that) by a guy who calls himself DarkStar. It doesn’t address the stop running claims, but it should give a good background on how the market is structured, the difference between a market maker and an ECN, why prices vary from one broker to another, and why the spreads widen at news events. No, they’re not out to target you. It’s just lack of order flow.

I think his final paragraph provides a key point, “Nobody is going to make the argument that a broker is a trader’s best friend, but they still provide a valuable service and should be compensated for their efforts. By accepting a broker for what it is and learning to work within the limitations of the relationship, traders have access to a world of opportunity that they otherwise could never dream of capturing. Let us all remember that simple truth.”

Ok, to answer your question, do brokers run stops?

Traders have been claiming this forever, not just in forex, but in futures pits, options markets and even the less liquid stocks. There are arguments for and against, but I don’t think it’ll ever get resolved.

While I have no doubt that a broker may lean on price a bit to move it to take out stops, I don’t think it’s as big a problem as is commonly claimed.

Market makers exist to make a market. That occurs through facilitating trade. If price can be moved a pip or two into a great pool of orders, it’s likely in their interest to do so.

Is it realistic though to expect that they can move the market a significant distance to take out your stops? Let’s consider how they could possibly do this. I see three options:

Firstly, I see three ways for your forex broker to move the market a significant distance to take out your stops.

(1) Market makers essentially make their own market. They could theoretically move their own market some distance away from all the other market makers/ECNs to take out your stops. In reality though, this is highly unlikely to occur. If a particular market maker was in the habit of moving their market too far from the underlying market, they would just be creating tremendous arbitrage opportunities. It’s not going to happen.

(2) They can work with all other brokers and market makers to move the whole underlying market in order to take out stops. For me, this option borders on the most ridiculous of conspiracy theories. The cost involved in moving a market say 20-30 pips, just to take out your little one mini-contract position, just doesn’t make good business sense.

(3) They can widen their spreads at appropriate times to take out stops, as in forex all your transactions occur at the bid/ask price. Like the first option above, this does not make good business sense. If a broker was in the habit of consistently widening spreads at turning points, in excess of other brokers, then they would lose business through providing poor service. It’s too much of a profitable business model as it is, without rising that sort of behavior and reputation. Hopefully the forum post linked to above will give you a greater understanding of when and why spreads widen. Of course, if you suspect your broker of this then you just need to make comparisons with others, and if you find someone better then move your business. Remember though, we’re talking about significant widening of the spread. It’s just not likely to be occurring.

So, if we accept that price can typically be moved small distances only, it’s most likely that those who are making claims of stop running are not really aware of the nature of price movement and are consistently placing their stops in poor locations.

Most market participants place their stops immediately beyond a previously established area of supply/demand imbalance, such as a swing high or low, or a support/resistance (S/R) area. I’d suggest though that this is perhaps too close and is simply placing you at risk of being stopped out as a result of normal market movement.

Price simply flows where net order flow takes it. And the net order flow is the result of the tug-of-war between the bullish and bearish sentiment of all market participants. Analyse the market from the perspective of order flow and trader sentiment, and you’ll see it’s quite normal to expect the market to test previous levels of supply and demand. And sometimes these tests will move short distance beyond where you’ve defined the supply/demand imbalance.

What is important is not that price breached this level, but how it reacts when it does so. Is it immediately rejected, supporting your original trade premise, or are the new price levels accepted, confirming the break of the level. In the first case, you want to still be in the trade. In the second, you don’t. So, if it’s reasonable to expect tests of those levels, maybe the stop should be a little further away?

My belief is that the stop should be placed at a position at which your trade premise is invalid.  If the trade premise is based around the concept of a S/R area holding (including swing high/low), then you have two options.

Firstly, you can propose that the level is so strong that it will never be tested again, in which the stop can be placed immediately beyond the level. The advantage of this approach is that your risk is as small as possible when you are completely wrong. The disadvantage is that you may get stopped out if price does test the level and breach it by a point or two. But that’s fine – accept it – that’s the risk you took by assuming this trade premise.

Secondly, your trade idea could include the possibility of a test of the level which breaches slightly before rejecting prices. In this case you’ll place your stop some distance beyond the level in order to allow for a test and breach. The advantage is that you’ll survive the small breaches. The disadvantage is that your loss is larger when the level fails.

My default position is to always allow additional room for a test of the stop level, placing the stop at a level I believe price should NOT get to if my trade idea is valid. However, there’s no right or wrong way to do it, and at times I won’t allow extra room. Your trade idea should be based on your assessment of the price action. Make a decision and live with the consequences. Take responsibility for your own results.

As I said, I usually allow some room for a test and breach of the S/R level. Even then, I still sometimes get stopped out, before price reverses. It’s part of the game. It’s not the market taking me out. It’s my failure to properly align myself with order flow. Learn from it and move on.

So, what can a trader do?

1. Trade liquid markets.

2. Place stops at positions such that your trade idea would be proven invalid. This way, if it’s hit then you want to be out of your position.

Sometimes this may be one tick beyond the S/R level or turn point. Other times it may be further. Base the decision on your assessment of the current price action and its potential for testing of the level.

If the stop is hit and price reverses, accept it. There’s no-one out to get you. You were just out of sync with the order flow. Take responsibility for the result. After all, you decided to place the trade.

Learn what you can from the trade. Was your setup valid? Was your stop placement valid? The market’s tendency to test this far beyond the level gives you perhaps important information about the sentiment of the market participants who drove price that far.

3. Be prepared for trade setups that develop as a result of other traders being stopped out. (See this followup article for an example) http://yourtradingcoach.com/trading-process-and-strategy/setups-based-on-other-traders-stop-areas/

Happy trading,

Lance Beggs

 

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YourTradingCoach – Admin

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