Today I'd like everyone to welcome Michael Michaud from Invest2Success.com. Today he'll be bringing us the finer points of stop losses...enjoy and please feel free to comment!
Do you use stops on all your trades? Trading without stops is the ego wanted to never be held accountable to admit that a position was a mistake if a certain level is breached or if a certain set of circumstances play out in an unexpected manner.
Let the market take you out. This takes your ego out of the decision - this decision on what stop level to exit should be calculated before entering the trade. Again you want to prevent your mind playing tricks by rationalizing a new reason to hold on to a poor performer. I review my trading journal each day in order to remind myself of the #1 Entry Driver for the positions and key stop levels. If any of these are broken, I have lost the edge projected and should exit such busted trade’s immediately.
Most traders think of stops relating to their exit of a position, but one of the most preferred entry techniques also involves a stop. A stop order to buy (or "buy stop") becomes a market order when the price trades or is bid at or above the stop price. A stop order to sell (or "sell stop") becomes a market order when the price trades or is offered at or below the stop price. The objective here is to only buy when the price takes out a significant prior high, or sell when the price breaks to a meaningful new low point. In this way I make the trade prove to me that it wants to make the anticipated move. If it doesn't, I don't get into the trade. Many times this method is far superior to the limit order technique of trying to buy below the current market price or sell above the current market price. What I generally have found is that limit orders hoping for a better price are merely another ego behavior to believe that we can tell the market what we want it to do. In turn when I missed out on getting filled due to a tight limit order, I was often left watching from the sidelines as the price mounted a continued trend. The stop entry has triggered me into some trends that I would have otherwise missed.
You should define an initial stop point for your trade, before you enter the trade. This determines the risk you are willing to take. The whole purpose of a stop in my opinion is to define the point at which the trend is invalidated. The potential reward should preferably be three or more times the risk you are willing to take. Next, you need to determine if a position is working for you, how will you protect your profits? This is known as a trailing stop. In a good uptrend, I prefer to use a close under the 10-day exponential moving average as my trailing stop, unless I am using another method as my driver in the trade.
At this point, let me explain my preferred stop method. I tend to use "closing stops", meaning I don't want to place my stop order intraday to be gunned by the floor or taken out by day-trader noise. Many battles are fought during the trading day, but the war is won at the close. We want to wait to see who wins the war at the end of each session. If XYZ stock is going to close against my closing stop level, then I place a market order to close the position in the final minutes of trading (if you miss this exit as subscriber for any reason, you can still place a market order to exit on the next morning's opening price). If the stock happens to be within a few cents of this level and it is unclear, I will wait for the close, and if my level breaks, I will make sure to sell it at the market on the next trading day's opening price. This has kept me from getting whipped out of a number of good swing trades during the day, while still giving me the ability to exit when the stock has proved me wrong by day's end. Some worry that a stock may move too far against them by the close compared to an intraday stop, and occasionally a stock will be filled well against our closing stop by the end of the day. But that risk is small compared to the bigger risk of getting whipped out of a position intraday, only to have it post a strong reversal in our favor and be off to the races. I call these "Bend But Don't Break" points. You want to wait for the end of that bar's close. If the chart is a weekly chart, wait until the end of the week's close to stay with the true trend while others will tend to get faked out.
The final exit issue I'll deal with here is how to take profits. Should we use a fixed target, or should we only use trailing stops on winning positions until the trend breaks? The answer depends on your risk tolerance, as well as the market environment. For conservative traders, I recommend sticking with price targets compared to defined risk levels, as you can lock in profits more safely that way. In addition, in more choppy markets the target profit approach is advisable, as noise can work to your advantage in taking profits at targets. But in trending markets, we want to be able to keep at least a partial position on, and then use a trailing stop like the 10-day exponential moving average to stay with the best trending situations.
Investor and trader since 1989. Writes daily for his blog Invest2Success.com on a variety of investing trading subjects.