Rule 4: Always use Open Protective Stops (OPS)

An Open Protective Stop (OPS) is an open order to exit a long or short position should prices move against you to a specified price. OPS's act as insurance against an unusually large loss, though the actual fill price may be less favorable where fast moving markets squeeze liquidity or when, in futures, limit moves cease market trading before the OPS is executed.

Before you enter any order, always determine the maximum risk you want to take. I call this Theoretical Risk. Theoretical risk is the distance between your entry price and your OPS. As shown in Figure 1, if you get into a stock at 10 and place an OPS at 8, your theoretical risk is (10-8) = 2 points. Winning traders know it's important to not only use OPS's but also, position them so that the theoretical risk is kept at 2 percent of capital or less. For example, if you have a $1,000,000 account, you should only risk $20,000 per trade in a theoretical risk.