The Importance of Stops

The Importance of Stops

Now that the grains and softs have taken a breather – maybe temporary, maybe longer – I thought this would be a good time to talk about stops. Especially as I’m scrambling to set mine!

This is basic stuff, but it took me almost three years of trading to figure out. Always use stops – don’t ride a position into the ground. At the heart of it, we’re speculating here – we’re not value investors who are content to buy more at cheaper prices. If the market tells us to get out – we need to get out!

I had a hard time getting this through my thick skull. I was used to the equity value investing school of thought – if you love a stock at $10, you should really love it at $7, because nothing has fundamentally changed about the business, and you can now buy it for less. Well that’s great if you’re Warren Buffett, but not so great if you’re trying to catch a run in soybeans.

If prices drop, the market is telling you something – that you’re wrong! Yes, there are corrections in every bull market. So it’s important to set stops ‘outside of the noise.’ Depending on your trading style, you may allow for a correction, but you don’t want to ride the downside of a trend – unless you switch your long position to a short!

Tonight I put in the following stops:

  • May ’08 Soybeans at 1480
  • May ’08 Rough Rice at 17.05
  • May ’08 Cotton at 82.50

I have some more work to do on these tomorrow. But the basic idea is that if these prices are hit, I’m out. I’m willing to give back some of my gains from the past few weeks, but I certainly don’t want to give them all back. So if these stops are hit, fine – I’ll concede that this leg of the bull market is over.

What happens if the stops are hit, and the market rallies? Personally, I will wait until a new high is hit. So if soybeans drop all the way to 1450, I will be stopped out at 1480. If they then turn around and rally all the way up to 1600, I will buy back in when a new high is hit – and the bull market is confirmed to still be in place.

The downside of this strategy is that I have to give up some gains. However I will take that trade, in order to make sure I’m out of the market for any nasty corrections. Look at any historical chart, and you’ll see that any large spike has two sides – the sharp run up, and the subsequent sharp run down. Please make sure you’re only on the front, profitable end of the spike!