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EXITS & STOPS, PART III

6) Types of Stops

● The Money Management (MM) Stop

This is the kind of stop where you get into a trade and place a stop that allows you to lose only a fixed dollar amount. The goal of these stops is to prevent a trader from losing more than he can afford to lose on any given trade, but in my opinion, these are the most commonly misused stops there are and should not be used the way people use them. The problem rests with the fact that the stops are placed with no regard to what the market is doing. Risk is as much a function of the market as it is of what a trader can afford to lose.

MM stops also can be a problem when one is trading different markets. Some markets are more volatile than others, and what may be a good dollar amount stop in one may not be so good in another. Using an arbitrary dollar amount to risk is a lazy man's stop, and everyone knows the lazy way is never the best way to do anything. Finding a good stop area takes work and is based on technical analysis, not on how much a trader can afford to lose.

The proper way to use a MM stop is in conjunction with a technically placed stop and the size of your position. By this I mean that first one should know how much one feels comfortable risking and is willing to lose on any single trade. A trade should never be made without knowing first how much is at risk and how much one can afford to lose.

● Percentage Move (PM) Stops

As with MM stops, a PM stop will tell you how much it is okay to risk on a trade but should be used only if it is technically feasible. With a PM stop one can use the market itself as a way to figure out the most one is willing to risk per share. For example, one could risk, say, no more than 30 percent of the daily average true range on any given trade. When I'm day trading, I try not to allow myself to lose more than 25 to 30 percent of the average true range of a stock on any single trade. If a stock has a true range of $2 per day and I'm down more than 85 cents, I know I'm doing something wrong.

Always use a higher time frame in figuring out the percentage you are willing to risk. If you are holding trades for the long term, you should get the true range of a weekly or monthly chart to figure out how much is an acceptable loss.

● Time Stops

Stops do not always have to be set by the market or on how much money you can afford to lose; they can also be time stops in which you give the market a limited amount of time in which to work itself out. If it doesn't work, you get out.

One of the important reasons for using time stops is that one sometimes have a habit of holding on to losers for too long. Maybe the stock is down only marginally and is not hurting you, and so you ignore it. As time progresses, it becomes 20, 40, 60 cents, and before you know it you've held a bad trade for over 2 hours and are out almost a dollar. Now you really don't want to get out because you want your money back.

Time stops helps you to liquidate your position before it can do you a great harm. A trader should have an expectation of what he wants the market to do and a time frame for it to do it in. If the market doesn't, he should consider exiting the trade -- win, lose, or draw. Depending on the time frame you use, it can be 1 minute if you're a scalper, 15 minutes if you're a day trader, etc.

I recently started using these stops as a way to get out of dead positions. If I'm day trading and have a position that is not working after 30 minutes, I get out because I know my money and energy are better spent elsewhere. If a trade was good, then it should have started working immediately. Things that start off badly usually end badly.

 

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(Continued)

● Technical Stops

Here is the proper way to place a stop: let the market tell you where it should be placed. Stops that are based on what the market suggests is a good place to let you know you are wrong are the best stops. The advantage of using the market to determine risk is also that the risk becomes clearer and can be kept small. If it appears that the risk on a trade is too large, the trade is not a high probability one and should be avoided. Don't worry about missing trades. The worst thing that can happen is that you won't make any money. Not making money beats losing money every time, and there will be countless more chances to trade.

There are many ways to use technical analysis to place stops. They can be placed outside trendlines, moving averages, channels, support and resistance lines, the low of x bars ago, below a Fibonacci retracement level, or at previous market lows or highs. These are areas the market is likely to come to, and if they are broken, that may indicate a change in the direction of the market.

Chart 9-3 includes a couple of trades one can make. The first one (Point A) is a breakout of a previous high. If a trader made this trade and could afford to lose only a dollar per share, he would have to place a stop at N (which stands for "no"). This stop is very likely to get hit as it is above the channel and trendline and in the middle of nowhere. It doesn't get hit, but nevertheless it is a poorly placed stop. The better stops are at Level 1, under the channel line, which coincides with the previous low of the market. If the market breaks that level, the next stop will be at Level 2, which is a better place to have a stop as it is below a major trendline. Finally, one definitely would want to be out if it broke at Level 3, a recent major low. Overall, I don't think this is a great trade as the stop levels are quite a distance away. However, at Point B there is a great trading opportunity as one could get in and risk to the channel line at Level4, which is pennies away. Levels 5 and 6 are similar to Levels 2 and 3. Needless to say, the stops at Levels 3 and 6 are just too far away at about $7 per share, and so they would be out of the question. The stops at Levels 2 and 5 are more modest but still a little too far away for the day trader and should be used only by a long-term trader. The stop at Level 1 is still a bit too far off, and so that trade could be ignored in this time frame, but since the stop at Level 4 is a technically good stop and is close to the market, it is a great place to take a trade. Tight stops are okay to have when they are technically correct. There is, however, one other possibility a trader could consider. Since the trade at Level A is a breakout, it could be taken, and one can use a move below the break line as a stop.

 

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EXITS & STOPS, PART IV

7) Why Stops Get Hit

The main reason stops get hit so often is that the masses tend to place them all in the same place and the floor brokers and pros know where that is. Besides having the unfair advantage of brokers on the floor actually telling each other where they have stops, they also know that traders are very predictable. People tend to place stops too close to technical barriers that are a stone throw from being elected; it doesn’t take much to get the market close to them and then push it a little more to reach those stops. After a quick burst as they get elected, the momentum dies out, the market snaps back, and the floor traders start liquidating, having gotten into the market at the highs.

Some traders end up having stops that are too tight and don’t give their trades the room they need to develop. This is influenced by the fear of losing too much money on any trade, taking the saying “Cut your losses” too seriously, or not having a clue where to place a stop technically. Hence, poor traders place their stops within the market’s regular movements or inside a trendline and then get frustrated when they are stopped out near the low of the move. They may have been correct in their assessment of the market, but if they entered at a bad level or the market was volatile, they would get stopped out, not having given themselves enough room to take advantage of the pursuing move. After they were stopped out and the market started going the way they thought it would, they might get right back in – usually at the same place where they entered before.

Stops that are too tight are a surefire method of losing money. Yes, losses will be small, but by placing stops within the regular trading range of the market, these stops will be hit and many trades that could have been winners will end up being small losers because they were never allowed to develop.

The flip side of having stops that are too close is having stops that are place farther than they need to be. Having stops that are too far is senseless. If someone is using a set dollar stop, he can end up putting the stop way beyond a safe place. What happens then is that the market goes to where a proper stop should have been and then keeps on going, eventually reaching the stop. A trader may end up losing $500 when he should have lost only $300. There are times, however, when a stop has to be placed at a great distance away from the market, such as when there has been a substantial move. In such a case, a trade should not be taken since the risk far outweighs the reward. It is better to wait for a safer opportunity to come along than to risk too much.

Stops should not be based on how much you can afford to lose; instead, they should be placed where the market tells you a good spot is. To avoid getting stopped out needlessly, never place a stop where you think the market should go; place it a safe distance away from where you gut tells you. Never place stops near technical levels such as trendline, moving averages, previous highs and lows, congestion areas, and round numbers such as 10,000 in the Dow. These are too obvious and are very likely to get hit. When a market has made a triple top, you can be sure that there are loads of stops just above that area, which traders may try to trigger. At least the pros know that that’s where there is easy money to be made. If the market is just drifting around by these levels, it doesn’t take much for a couple of locals to lift it a few points to hit those stops. Since these moves are not based on proper fundamentals, the market tends to come right back to where it was before the push. Remember, don’t place stops at very obvious levels; think twice about where you are placing them and use a little bit of a buffer to give you some breathing room.