After plunging to a four year low versus the USD in reaction to report Germany has temporarily banned naked short sales of government bonds and default swaps the EUR posted a sharp short covering rebound in US trading session Wednesday. The ban on naked short selling is to try and prevent speculative assaults on German financial markets. German officials believe that speculative assaults, particularly in EU bond markets helped to drive up the cost of funding EU debt and exacerbated the EU debt crisis. Whether the German ban on naked short sales will be successful in discouraging speculative assaults on the German/EU financial markets remains to be seen. So far the ban has added to market panic and skepticism. Traders generally find ways around trading curbs and according to a Bloomberg report Germany took the action to ban naked short selling as a political move to show that the German government is taking action to try to defend the EUR.

The EUR traded at the four year low of 1.2143 in European trade and surged above 1.2350 in the US trading session. One explanation for the sharp rebound in the EUR was a rumor that the ECB is holding an emergency meeting and soon may announce a Euro Zone wide ban on naked short selling. The fact that Germany so far has acted unilaterally in its action to try to discourage excessive speculation in its financial markets generates concern about lack of cohesion among EU nations to tackle the fallout from the Greek debt crisis. A ban on naked short selling across the Euro Zone would be confirmation of greater unity within the EU community. This could increase the credibility of the German and EU efforts to help restore confidence in EU financial markets and the EUR. Investors remain skeptical about the efficacy of the near $1trln EU rescue plan announced earlier in the week for Europe. The plan does little more than buy time for Europe to try to deal with the debt crisis and offers limited solutions to the debt crisis. The same could be said of plans to ban naked short selling. The ban on naked short selling does not address the underlying fundamental problems facing the EU.

The EUR rebound Wednesday was also attributed to rumors of central bank intervention. There was a rumor that the ECB intervened in support of the EUR. There was a rumor that the Fed intervened along with the ECB to support the EUR. And the SNB intervened in EUR/CHF cross. EUR/CHF cross dropped to a record low with the CHF supported  by safe haven flows sparked  by the EU debt crisis and the German ban on naked short selling. EUR/CHF traded below 1.40 in overseas trade and surged above 1.42 in the US session supported by what appeared to be SNB intervention buying the EUR. SNB officials have consistently stated that they plan to take aggressive action to stop excessive CHF appreciation versus the EUR. Until today the SNB has been intervening unilaterally. G-7 members may be coming to the conclusion that in order to stabilize the global markets the EUR must be stabilized by intervention. There is a growing threat of Forex intervention from the ECB and possibly coordinated intervention with the Fed and other G-7 members.

The threat of intervention or actual intervention may disrupt or interrupt the current short-term trends in FX markets. This means that traders need to consider how intervention may affect Forex price action and their trading strategies. There are three main types of central bank Forex intervention. The first is rhetorical intervention. Rhetorical invention takes place when government officials and central bankers try to influence Forex markets with comments about a specific currency. The impact of rhetorical intervention is usually short-lived and it may be the prelude for physical intervention. Physical intervention is when a central bank buys or sells a currency to try to support a currency or limit a currencies appreciation. There are two types of physical intervention. The first is unilateral. This is when one central bank acts along. The second is coordinated. This is when central banks act in concert. In general, unilateral invention is less successful than coordinated intervention and there have been numerous studies questioning the effectiveness of either type of intervention. Additionally intervention that is not supported by underlying fundamentals will fail to have lasting impact on the direction of a currency. Our study of past currency interventions suggest that it’s easier to slow the rate of  appreciation of a currency  than to support a currency and the most effective intervention tends to be associated with the element of surprise backed up by underlying fundamentals. When intervention is expected the impact is generally deluded and limited. Most times central banks will refuse to comment on intervention to try to keep currency traders guessing. In contrast, the SNB has made clear its intention to intervene. Maybe other G-7 central banks will follow the SNB’s lead.

The fundamental outlook for the EUR remains negative due to uncertainty about whether the EU rescue plan will contain the contagion risk of the Greek debt crisis. The EUR is also vulnerable to concern that EU austerity measures will to slow the EU recovery and force the ECB to maintain accommodative policy possibly into 2012. The negative fundamental outlook for the EUR means that central bank intervention to support the EUR will likely have limited lasting impact. Central banks sometimes intervene into try to manage currency fluctuations and try and keep a currency within a given range. This is called a smoothing operation. A smoothing operation is designed to stop the rate of acceleration or deceleration in a currency market price direction not to try to change the overall price direction of a currency. Unless something dramatically changes in the fundamental outlook for the EU, intervention at this time will likely be limited to smoothing operations. One factor that may work in favor of ECB and/or coordinated intervention is statement from the IMF that the EUR is nearing equilibrium. According to the IMF’s Lipsky the 18% decline in the EUR since the beginning of the year is positive for EU exports and long-range growth. We noted in a special report Monday that the EUR is approaching major technical support at the 50% retracement level of the record low in the EUR at 0.82 from the record high above 1.60. The 50% retracement of range comes in just above 1.20. Central banks may have temporary success supporting EUR above this level. We suspect that intervention in EUR will be seen as opportunity to sell the EUR at a better value and the threat of intervention will have limited lasting impact.

Note in the graph below the impact of rumored SNB intervention in the EUR/CHF cross.

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The great advantage of a non-numerical stop-loss order is its partial immunity to price swings. If the trader has confidence in his analysis, and is satisfied that standing firm in the face of market volatility is sensible and acceptable given the major dynamics and currents in the market, maintaining positions with non-numerical stop loss orders can be advisable and lucrative. In order to manage the inevitable massive swings in account value, professional managers will implement hedging strategies in addition to money management methods, to control and minimize the volatility of the portfolio. Thus, even if the mental stop triggers a massive drawdown in our position, they can minimize the effect on the portfolio through diversifying and distributing the risk among various funds pairs.

An equity stop is two where the position will be closed in case the total equity in an account falls below a sure value. A stop loss at 2 percent of total equity is generally regarded as a conservative strategy, while the maximum is 5 percent for most money management methods. Thus, to give an example, a 1000 USD account would have the stop loss for an open position at the point where to the total equity would fall below 980 USD.

Let us examine the various ways of implementing a stop-loss order now.
Equity Stop

Another important problem with the equity stop is its inability to prevent a string of losses. For instance, when the trader closes a position at a three percent loss, there’s nothing that will prevent him from opening another position in the same direction (buy or sell) a small while later, if the causes that justified the first trade are still in place. For instance, if the trader enters a sell order when the RSI is above 80, and consequently the stop loss is triggered, and the position closed, there’s small that will prevent the same events from being repeated if the price action repeats the same movements. In order to keep away from this pitfall, the trader can tie the stop loss point to a non-price factor, and the rest of this editorial discusses such scenarios.
Chart Stop

Both the disadvantage and the advantage of the equity stop is its inflexibility. The equity stop provides a solid criterion for deciding on the success or failure of a single trade, as there’s no way of being mistaken about an account in the red. On the other hand, the same inflexibility may prevent the trade from functioning as expected. The markets are volatile, and a trade that has a perfectly valid cause behind it may yet be invalidated by the random fluctuations that are not predictable.

The chart stop is more flexible and reliable than a direct equity stop, because it adjusts to price action and volatility, and is therefore independent of the random movements of the price. The problem with the chart stop is twofold. First, the technical indicator used to generate the signals may fail to capture the change of the market trend, resulting in massive losses. The other, and obvious problem is related to the indirect character of the stop-loss mechanism. Because the order is independent of the price, it may not be able to cut losses as effectively as a direct equity stop, and larger than expected losses may materialize as a result.
Volatility Stop

In a chart stop, the trader will place the stop loss order not at a price point, but at a chart point which may be static or dynamic. For instance, a stop loss order may be placed at a Fibonacci level, which would be a static value. On the other hand, the trader may use an API (an automated trading process), or mentally prepare himself to close the position if a technical event, such as a crossover, a breakout, or divergence occurs, which would constitute a dynamic stop-loss point. In all these cases, technical analysis generates the triggers and determines the price where the position must be closed.

A volatility stop is contingent on volatility indicators, such as the VIX for determining the exit point for the trade. As such, market panics and shocks will cause the order to be executed, but mere price fluctuations in the funds market which lack their counterpart in other asset classes will be ignored for the most part. The trader who utilizes a volatility stop expresses the opinion that unless a major, unexpected shock hits the market; his position should be held regardless of the behavior of the markets. This is a more dangerous strategy than the equity stop, but can be profitable and valid depending on market conditions and the economic environment. In general, it is doubtful that a volatility stop can be useful in a nervous and volatile market. But it could be helpful in maintaining a long-term position where risk perception is low.

The volatility stop is sensitive to prices, but only in an indirect manner, and its nature is similar to the chart stop. It is useful for eliminating short term distortions from our analysis, and allows us greater resilience in the face of noise in the information.

Volatility may fail to react to market swings. Sometimes a massive fall in the market has no equivalent rise in the various volatility gauges. Similarly, volatility can sometimes rise without any obvious corresponding price action. Consequently, a volatility stop (and similar stops based on non-price information) can be triggered even before a trade is in the red. All these must be kept in mind if the trader decides to use this type of stop order.
Volume Stop

When the trader expects an ongoing trend to be reversed or invalidated subsequent to a change in volume, a volume stop perhaps appropriate. While volume statistics are not available for the forex market, positioning as depicted by the COT document can be used for establishing this type of stop. For utilizing the order, the trader determines a percentage value on futures positioning above or below which the position must be liquidated, depending on market conditions and the nature of the order. In the same context, other types of information can also be used to generate a stop loss trigger point. A particular put/call ratio or option risk reversal value may all be selected to provide the equivalent of a volume stop in the stock market.

In example, let’s think about a trader who opens a short position in a carryover trader pair, confirming his trade by developments in the stock market. His expectation is that the recent rise in the stock market indexes (and the corresponding rise in the carryover pairs) occurred on low volume, and will soon be reversed without new money flows. Consequently, they places his stop-loss at a volume level which, if reached in a rising market, will invalidate the beginning premise, and cause the position to be liquidated. When this occurs, and volume rises above the preconceived level, the trader will close his short position in the carryover trade pair.
Margin Stop

The margin stop is not a stop loss order, but the absence of it. In this case the trader will let his account absorb the unrealized losses until a margin call is triggered, and a massive part of the account is gone. The margin stop is a sign of indiscipline and lack of insight, because a diligent trader will always predetermine the conditions that will lead to the closing and liquidation of a position. Since not even the brightest analyst is capable of predicting the future with any certainty, lack of a stop loss order is an indefensible practice.

Notwithstanding the previous, the margin stop is a popular choice among lots of traders who are unable to remain calm in the face of the great emotional pressures of trading. It is only viable under low leverage such as 2:1, and even then a margin stop would not be the best choice. At much higher leverage, the margin stop is indefensible, and should be avoided altogether
Event Stop

Fundamental analysts do make use of technical tools, if only for determining the trigger points for a trade. Take profit, and stop loss orders are used by every trader in the world, and its is unthinkable that a serious analyst won’t have a condition, at least in mind, for closing an open position, however convinced they may be of its ultimate validity.

But fundamental analysts are not limited to technical tools and the price action for determining when to exit a trade. The event stop that they would like to discuss here is a device that the trader can use to decide a trade’s exit point.

When using the event stop, the trader will ignore the price action for the most part (and will use low leverage), and will only close a position in the red when the scenario they had pictured in his mind becomes contradicted by events. For instance, a trader is anticipating that Bank A will be nationalized by the authorities of Nation X, and they expects that this will lead to X’s funds depreciating against its counterparts. In consequence, they short it. They will refuse to close the position until authorities confirm and clarify, in a solid and unmistakable fashion that they will refuse to nationalize Bank A. In the meantime, they will be willing to put up with all the rumors, extreme swings, and short term fluctuations in the market without worrying about the unrealized profit or loss in his account.

The best choice for the beginner is the equity stop. During the learning method, the trader can concentrate on bettering his understanding of the markets without worrying about excessive losses. Two time the trader gains a lovely understanding of market dynamics, and can form and implement his trading designs, the equity stop will quickly lose its attractiveness.

As they mentioned at the beginning, the event stop is for those traders who know what they do, and who possess the track record, the intellectual background, and the confidence to use it. But do not take our word in order to evaluate your own skills; you ought to know yourself better than anyone else, and if you believe that you understand the economic dynamics of the era, and can defend your claim in your trading activities, you will be perfectly capable of using the event stop.
Conclusion

Needless to say, every trader will have his own choices on stop loss orders. And they would like to conclude this section by noting that the key to a successful stop-loss order is a disciplined risk management strategy, and everything else is detail.

The best method for using the non-price stop orders is combining them with a wide equity stop which will serve as a final safety precaution in case the price action becomes unsafe. For instance, a trader can long the EUR/JPY pair and hold it indefinitely until the VIX registers a value above 35, where a volatility stop would be placed. Simultaneously they will protect from extreme, and unexpected swings by placing an equity stop at 5-7 percent of total equity. Thus, unless a massive price swing overruns the main criterion for the stop loss order, and triggers the equity stop, the trade would be maintained indefinitely.