Bracket Orders

DEFINING BRACKET ORDERS
A bracket order is actually a set of three different orders that set up an entry and pre-established profit-taking and stop-loss levels. In the case of going bullish on a stock, the bracket order is made up of a buy-limit order for entry, a stop-loss order below the entry, and a sell-limit order above the entry. (See Figure 1)

Figure 1: Bullish Bracket Order.

If you decide to short the stock, then the bracket order is started with a sell-limit order, and then bracketed by a stop-loss order above entry price and a profit-taking buy-limit order below the entry. (See Figure 2) This allows you to set up the trade and walk away, since the exit orders have already been sent to your broker.

Figure 2: Bearish Bracket Order.

BUILDING A BRACKET ORDER STRATEGY
Suppose one day you find you need to leave your workstation and deal with other important things in your life. You decide to use bracket orders to set up a few trades. How many can you set up? That depends on the size of your account, your money- and risk-management protocols, and your profit goals. For the example, we will assume a bullish trend.

Choosing your stocks
The first step is to find a few stocks with a clear trend going for the day about to open. You will have to rely on your favorite analysis technique to define this trend, and most quality data feed vendors have some kind of stock screener. For example, you may look for stocks whose fast and slow stochastic have both given a bullish signal by going above the 20-line the day before. If you find plenty of those, you can narrow them down by looking for additional bullish signals in the MACD perhaps, or for some bullish Japanese candlestick patterns.

Defining the stop loss
Next, you need to figure out how much you are willing to risk on each trade. You should already know the answer to this, since it's a basic part of money and risk management. If your protocol dictates risking 1% of your trading account, figure how many shares you can buy without violating your 1% rule. In order to do that, you need to figure what price swing is acceptable for this stock. This may be determined by looking for resistance or support levels in the charts, or by whatever other technique you prefer. If you are a daytrader who normally hunts in the 5-minute bar charts, you may want to do your analysis based on a 30-minute bar chart so your trades have some time to mature during the day and statistical noise doesn't stop you out prematurely. Once you know when to stop, figure the number of shares you can buy by measuring the difference between the stop price and the probable entry price, and then dividing your risk limit by that difference. (See Step 1)

Step 1

Let's say for example, we find that XYZ stock has a solid resistance level at 49.50 and we have the opportunity to enter a limit-buy order at 50.00. That means we have a 50 cent difference between probable entry and stop-loss. If we have a $100,000.00 trading account and a 0.5 % limit of that to risk per trade, we can only risk $500.00 on each trade. This limits our position for this trade at 1,000 shares of XYZ.

Defining the profit goal
The profit goal should be determined as a fixed multiple of the amount to be risked. This will allow the system to actually take a profit while you are away. It may violate one of the golden rules of trading since it does not let winners run, but since you may not be there, that's okay. The multiple you choose is up to you, but two or three times should allow you to keep your average profit in the black. So, if your risk limit is 1% of account value, then your profit would be 2% or 3% of account value. To determine the price at which you will take a profit, take the price difference you calculated in Step 1 and multiply by, let's say 2, and add it to the probable entry price. This is your profit-taking price. In the case of a bearish position, the profit-taking price is the difference of the entry, minus the risk multiplied by the risk multiple.

Step 2

For a bullish position:
Profit-taking price = entry + ( between entry and stop-loss X profit multiple)

For a bearish position:
Profit-taking price = entry - ( between entry and stop Loss X profit multiple)

Going back to our example, we know that our probable entry price at 50.00 and our risk limit per share is 0.50. If our strategy looks for a profit multiple of 2 then we determine that our profit-taking limit order must be placed at 51.00.

51.00 = 50.00 + (0.50 X 2)

Entry and setting the bracket
Now that we have our stop-loss price and profit-taking price, it's time to try to enter the market at the probable entry price. To enter the market in a bullish trend, you should place your buy-limit order, the stop-loss order, and the sell-limit order simultaneously. This is your bracket order at work. So in this example, you transmit the following orders to your broker:

Step 3

BUY LIMIT XYZ @ 50.00
STOP LOSS XYZ @ 49.50
SELL LIMIT XYZ @ 51.00

If, for some reason, you have to adjust your entry price, you can adjust the other orders accordingly to maintain the same risk limit and profit potential. Make sure that all positions will close at the end of the day if neither the profit-taking limit order nor the stop-loss has been triggered -- you may not want to go into the unpredictable after-hours with an open position. In addition, you may want to check with your broker about order-routing procedures to make sure you can execute this strategy; and make sure that, in case the stop-loss order is triggered, the corresponding profit-taking limit order is cancelled, and vice versa.

NEW TO TRADING?
If you are a novice trader, the bracket order strategy can give a general feel for the market and help you get comfortable with order-entry and exit procedures.

Bracket orders help take the emotion out of the exit, where money is made or lost. The entry opportunity in an intraday trade can be found by many different technical analysis techniques that range from very simple moving averages to customized indicator matrices. Once your chosen technique has given you the go-ahead to enter a trade, your emotions come into play. If fear keeps you from entering, there is no harm done, since your capital is safely in cash form. But if you will yourself to pull the trigger, your money is now in jeopardy. It is now up to your exit to turn a profit or limit your loss. By using a bracket order to close your position, the emotions that may sabotage your trade are taken out of the picture.

Since both the stop-loss and the profit-taking limit order takes some of the decision making away from you, the bracket order acts like training wheels until you feel at ease in the market. Once you are ready to move forward, you may stop using the profit-taking limit order and let the profits run. Finally, you could drop the automatic stop-loss, which is, after all, a triggered market order -- and we all know market orders are the unacknowledged fourth member of the Axis of Evil because they are more likely to spawn slippage.

BEYOND THE BRACKET
You can add bracket orders to your playbook of trading techniques and strategies and take care of the rest of your priorities without taking a day away from trading. New traders can use this self-executing exit strategy until they feel ready to take a more hands-on approach to order entry and position closing. In addition, bracket orders can be a valuable part of your risk-management strategy in case your trading room is in a geographic area with an unstable power supply or erratic Internet access. For these and other reasons, this simple execution strategy can help you build a more solid risk- and money-management strategy.

SUGGESTED READING
Chahin, Roberto [2004]. "Breakeven Analysis for Daytrading," Technical Analysis of Stocks and Commodities, Volume 22, October.
_____________ [2005]. "Self-Discipline Vs. Self-Sabotage," Working-Money.com, April 21.
Thap, Van K. & Brian June [2001]. Financial Freedom Through Electronic Day Trading, McGraw Hill.

Roberto Chahin is a business and personal financial advisor who is now a full-time trader based in Tegucigalpa, Honduras. He may be reached at robertochahin@yahoo.com.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.