The only purpose for using Stops is to protect your capital.
They are used either to cut losses or to protect profits.
Stops are usually based on some dollar figure rather than a market indicator or price pattern.
A characteristic that stops share with exits is they force the strategy out of the market, which then requires a re-entry.
We should give this re-entry caused from stops the same thought and attention that you would give a re-entry for exits.
The first stop we should consider is the stop to limit your losses or money management stop.
This type of stop define the maximum amount of money that you are willing to risk on any one trade.
It must be placed after the initial entry and must not be moved.
The decision to place this stop is dependent on the strategy.
One thing to remember is that the volatility of markets changes over time, and what has been a good money management stop for the last few years may not be appropriate now.
So keep in mind that if you use money management stops, you should keep testing for the appropriate level.
You will know that your stop is not appropriate when you get stopped out of a move too early because your stop interferes with market action.
Another stop you should consider is the profit protection stop, trailing stop.
It protects profits once the trade has moved in profitable direction.
A trailing stop keeps moving with the profits.
For example, in a long trade, if the price has moved up in your direction, you would also move the stop up.
Money management and trailing stops can also be combined to limit the total risk of any one trade.
For example, the initial stop loss might be $1,000 away from the entry price.
This limits your loss in the worst case scenario to $1,000.
Once the strategy moves into profitability, a trailing stop is placed $1,000 away from each day's closing price.
When the profit reaches $1,000, your trailing stop would be at break-even.
If the price continues up, it would result in the trailing stop being moved up to protect even more profit.
The use of a stop depends on your trading style and risk aversion.
However, stops are less important if you have spent the time and energy to develop a sound set-up and entry strategy.
The use of stops will not make a poor set-up and entry strategy sound.