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.
Michael Michaud
Investor and trader since 1989. Writes daily for his blog Invest2Success.com on a variety of investing trading subjects.
I have not used stops yet. I probably should. My trade timing is a week to a month usually. I look at the 6 month, 1 month and 5 day online charts to trade. I look at 3 line EMA, Bollinger bands, and +/-volume, Momentum and RSI on a daily basis to judge when to get in and out. My last long term trade was 10 contracts for GLD. In at 67 and out at 98. It went over 100 and I saw the top and sold.
I use Schwab for all trades including Options. I trade on-line with no broker interference. I pay under $15 for 10 0ptions contracts so it is cheap. No fees for direct securities purchases.
Fidelity also does not offer end of day or closing stops. Because several newsletters I read recommend them without explaining what they really are or how to execute them, I called my broker to understand what they really are. He didn't know and as best we could figure out it is a mental stop with a certain amount of subjectivity at the end of the day. Questions:
1) Is there backtested evidence that mental stops evaluated daily or weekly perform better than automated stops?
2) Doesn't this subjectivity of evaluating the stop at the end of the period pull your ego right back into the trade? Now you have to decide whether to double down when the trade goes against you?
Cecilla, if I am reading your questions correctly, technically it could or could not be the same thing.
The difference depends on the particular stock. If Stock A has huge swings over the past couple of days, then that 10-day exponential moving average may or may not be equal to 4-6%. The same could also be said if the stock does not move at all. The 10-day moving average could be smaller or bigger than 10%.
I use the PSAR with default settings to set stop losses. What I am not sure about is if I should use the daily/weekly/monthly charts. I have been using daily and found that the stops can get too tight and I get stopped out of trade during whipsaws, so I recenlty switched to weekly. I have to see how PSAR based on weekly will perform.
From my limited experience I see that stop losses are very tricky - striking a balance between protecting your profits or minimizing your loss on one hand and avoiding getting stopped out because of whipsaws is a challenge.
Please share your experience if possible.
Trikaal
My understanding is that there are (at least) two different ways to put on a stop: 1) by a specific dollar amount; and/or 2) by a specific percentage amount.
Therefore, using the suggested 10-day EMA would be an example of a stop order based on a dollar amount (that you change/pay attention to at the close of every day), whereas a "tight (4-6%) TRAILING stop will adjust itself accordingly on a constant basis throughout the day.
A "looser" trailing stop could be 8-10%, which would give you a little more "wiggle room" depending on your trading style and the volatility of the stock. Also, with leveraged 2x and 3x ETF's a 12-15% stop, while pretty wide, might be necessary to keep you from getting kicked off of those wild horses.
You basically have a choice $ or % - narrow and tight OR large and loose.
I hope that helps.
Can somebody explain what is mean by putting on a moderately tight (4-6%) trailing stop? Does it similar to 'prefer to use a close under the 10-day exponential moving average as my trailing stop'?
I trade with TD Ameritrade. I do use stops, but find they have flaws on that platform. They don't offer AFAIK stops on close, by the way, and what's wrong with those is just as bad as what I'll describe.
I've used stop loss orders to prevent a trade going against me, either due to inattention, or due to ego (more likely the latter, I pay close attention when I don't have guests present). I have also both lost money and left it on the table due to these. The regular stop orders can trigger due to one big trade, that moves the price a lot for just that one trade, or only a few seconds at most -- there's no median smooth over a few trades you can ask for. You can "theoretically" avoid day trade noise by setting the stop wide, but this means more risk that it won't trip at a good execution price, also. Any stop at say 8% may actually be a stop at 9% or more if the market is moving fast. It's a very imperfect tool.
And that's the problem with stops on close (or any fixed time) -- other than the simple fact they're not available at my broker. In these nutso hysterical markets, stopping out intraday can save quite a fat loss from happening by the end, if something just goes bad -- look at LDK today for an example. Might have been nice to have a pre market stop there? But many other different cases apply -- just as the market zooms when the mood is good, it tanks on the other side, and a human can see this a little earlier and take action before a stop set "out of the noise" can, and be mostly right.
I've found percentage trailing stops very useful in one situation. This is when I perceive a trade has about run its course -- for longs, either it's looking like going over the top of a sine curve (and my money should be somewhere else in a fast-rising issue), or it's doing that panic exponential concave-up rise that usually signals an end soon, because the last buyers are all on board now. But hey, it may zoom a little more in the latter case, or turn around and then keep going up in the former. So at that point, putting on a moderately tight (4-6%) trailing stop makes you money and makes it easier to sleep well -- and you capture more gains that way.
YMMV of course, but that's how it's been in real experience for me -- paid for in lost bucks. Maybe there's a better broker, but I don't know of it, and I like that the commissions where I am are in the noise for the size trades I usually make.
The rules may be different for someone not a swing trader as I am, and trading from the gut, but these are what works here.
I don't put stops on at buy time. I could, but have too often "drawn to an inside straight" lately to want to always exit a position at say Bill O'Neills 8% rule -- sometimes I may buy more at that point if I still believe in the trade, and history seems to say this little drop won't hold.
Not advising anyone else to do this, ever, at least until you've studied that issue and markets for quite a long time -- this can be lousy if you don't know the underlying things quite well.
BTW, the numbers I'm using are all for straight equity trades, mostly in high beta stocks, no leverage.
Rules would of course be different depending on how the trading instrument normally behaves.