Chapter 12. Setting Stops
I have often heard that you know you are fluent in a language when you dream in that dialect. This makes a great deal of sense. After all, when something becomes so ingrained in your psyche, you no longer have to even think about that action; you just do it. This is true with both innate physical reactions, such as when my newborn child squints at a bright light or jumps at a loud noise, and with learned habits, such as buckling your seat belt when you enter an automobile. Many of our habitual learned activities are those that help us remain safe. This is no different from trading when it comes to setting stops. Just like when you buckle your seat belt or look both ways before crossing the street, stops must become so ingrained into your daily trading routine that they are nothing more than a natural part of your investing process. The litmus test of when you know you have truly embraced this idea is when your anxiety level doesn’t increase from being in a trade, but instead increases only when you are in a trade without a stop.
When I first started trading stocks, I looked only for the opportunity for gain when I reviewed a stock, either long or short. I was so engrossed in the potential for profits that I never thought about the potential risk and, therefore, a stop was often an afterthought, if it was a thought at all. This thought process was flawed, and it hindered my growth. At present, when approaching any trade, a stop is the first thing I ponder, and it becomes the foundation from which my entire trading plan is developed. Whenever I review any potential trade, regardless of the direction, before going any further I first ask myself where a stop should be in the event I am wrong and the trade does not work.
A disciplined stop system is critical for proper execution and serves as the foundation for consistent success. While successful trading will ultimately be determined by profits, you will not be profitable on every trade taken. Therefore, to make money, your edge must give you a higher probability of profitable trades over losing trades throughout a longer period of time. In summary, your lasting success as a trader will be determined not by one individual trade, but by the continued execution of your overall trading strategy. It is for this reason that a losing trade may actually be considered successful if the trade was executed properly. As ridiculous as this sounds, it is imperative for you to understand this concept. The great stocks will flow into your account, as will many stinkers. The key is to keep all losses within the confines of your predetermined risk parameter so that you can continue exercising your edge regardless of losing trades. You can do this only by setting appropriate stop losses on each trade taken.
A fine line distinguishes remaining in control of a trade and basing your trade on mere hope. This line will always be quantified through your stop. Traders who experience consistent failure rather than consistent success often do so because they refuse to accept losses and move on. When a trade is no longer working, or the original idea you had for the trade is no longer valid, it becomes imperative for you to exit this position immediately. Changing your strategy or your ideas mid-trade is similar to a quarterback attempting to change the play after the ball has already been snapped. Sometimes such changes will work to your advantage, but more often than not they will result in a costly financial lesson. I often run into traders who refuse to adhere to proper discipline through stops, and because of their refusal they consistently cross the line from controlled trades into hope trades. Not only can the financial damage be significant, but spending days and nights hoping a trade starts to work in your favor is down-right exhausting. A trading journal, with a written trading plan for each stock, can help you remain accountable. However, only the self-discipline to adhere to your predetermined plan will foster success.
More than likely, you have experienced this world, where you are just watching and hoping a stock reverses to go in your favor so that you can either exit the trade for a smaller loss or possibly even a profit. Even if this reversal happens, the longer-term damage that occurs as a result is often worse than the loss that would have incurred if the stop were taken in the first place. Let me explain.
Imagine if you will, laying out a specific plan when approaching a stock. You have identified a pattern that may give you an edge and move in with your purchase or short sale with an identified area at which you would take the tradeoff if it did not work. Over a period of days, the stock reverses and quickly moves toward your predetermined stop. It is at this point that rather than preparing to exit, you begin to hope another reversal ensues. Soon, the trade falls below your stop, and rather than exit the trade, you decide to give it just a bit more time to see whether it will play out. You rationalize this behavior by accepting the small change as nonmaterial. Little do you realize this can be a very damaging decision with implications beyond the obvious financial loss. For this example, let’s assume that instead of continuing its plummet, the trade reverses and not only returns to your basis but also shows you a profit. Instead of feeling proud of your execution, you feel relieved and empowered by your resiliency and fortitude, almost believing you were in a fight with the stock and came out ahead. Much like a criminal getting away with his first few crimes, you now have an ingrained belief that as long as you remain steadfast, you will ultimately be rewarded for your resiliency. Unfortunately, this bad habit will eventually catch up with you. Although it might not be the next trade or the trade thereafter, at some point a trade that goes beyond your original stop won’t come back, but will instead inflict significant financial damage and erode your confidence level exponentially.
The key for you to realize is that all hope trades should be avoided. Whenever you feel you have crossed the line from being in control, to relying on hope, exit the trade immediately. Stops typically act as this line, and it is why respecting them can mean the difference between your sustained success and an eventual blow up.
Throughout the course of my trading career, I have come across a variety of stop strategies. I have also traded alongside those who set no stops at all. While I do believe that just adhering to any stop strategy is better than none at all, I also believe that most of the common strategies taught today only set up the trader for a tremendous amount of frustration. The strategy of stops is a subject that is neither dissected nor discussed nearly enough.
The most common stop strategy taught is based on a set percentage loss from which a stop can be placed. For example, I have often seen traders advocating a 5% or 10% stop loss on a trade. Of course, this can also be equated to a fixed dollar amount per share (for example, a stop of $.50 or $1 per share). As I stated, although I do believe any stop strategy is better than none at all, I find significant flaws with a strategy that uses a fixed variable to determine the point at which one is incorrect.
Rather than a fixed variable across a variety of different trades I much prefer to set a stop based on a level at which the pattern that originally attracted me to the trade is no longer valid. To me, this makes much more sense and does not open one up to the susceptibility of being stopped out within a pattern that is still valid. Of course, this moves the discussion toward position sizing and risk management, a topic we cover in the next chapter.
Let’s review again the Ford trade we used in a previous chapter (see Figure 12.1). Let’s also assume that you have taken the trade in anticipation of a breakout, entering Ford at $7.50. Adhering to a fixed stop loss strategy, you subsequently set a stop loss order 5% below your initial entry point. While Ford did not dip at all in our previous example, imagine for a moment that the stock had dipped to $7.10, or a few pennies below the 5% limit from which you set your stop. I have indicated on the chart where you would have been stopped out. What is important to note is that Ford would not have broken down; instead, the stock would have continued moving within the pattern that attracted you in the first place. The question must therefore be asked: Was this a good stop? From an execution standpoint, I believe that laying out a plan and following it is what ultimately determines success and, therefore, the trade was successful. The question becomes this: Is there a better way to set a stop? Although it would be frustrating to be down 5% in unrealized losses, it would be even more frustrating if you were to stop out of Ford only to see the pattern work as was originally intended.
Figure 12.1 Ford breaking above the descending angular trend.
Chart courtesy of Worden—www.Worden.com.
After reviewing your trade journal and cross-referencing the price action in Ford after you were stopped, it would be simple to declare that you just needed to widen your stop. You might even go so far as to adopt a new rule where you do not set a 5% stop, but rather an 8% stop, or maybe even a 10% stop. Again, it is important to relay that simply setting and adhering to a stop is excellent discipline. But what if there is a better way?
A few times in my career, I have worked with a trader who faced the dilemma of continuously being stopped out of a trade, only to see the trade move in the direction he suspected days later. The urge to simply widen the stops sets in. However, with this urge comes the potential for larger losses. On analyzing the strategy, I have found that typically the trader is setting a fixed percentage stop, rather than one that is unique to the pattern being played. With a case-specific small adjustment, the trader often eliminates this whipsaw action and many times remains in a trade, seeing it through to success instead of being stopped out prior to the desired move happening.
Your success in trading will often correlate with the finer points of execution that you will develop over time and through your growing experience. Take golf, for example, where a professional knows not only the appropriate club to use at each distance but also how to alter the club selection or swing for other variables, such as weather or where the ball is lying, be it in the rough or in the fairway. Professionals have learned this through years of experience, an intimate knowledge of their swing, and a full awareness of the performance they’re anticipating. Weekend warriors, on the other hand, may have only a vague idea of what clubs to use and when, knowing they hit a wedge approximately 100 yards or a solid 3-iron 190. While using the appropriate clubs at roughly the correct distances is better than putting with a 3 iron, or using a driver in the sand trap, there is a big difference between the general knowledge of the weekend warrior and the intimate knowledge of the professional. This difference between the two golfers is typically reflected in their score after each round.
Let’s look at a specific example that happened to me during the time I was writing this book. Figure 12.2 displays the stock of CBS Corp, which I viewed on January 15 as a potential trend change, and watched the stock break through an ascending trend line that began in late August. On seeing this action, I shorted shares of CBS Corp at $13.10 as a reactionary trade, placing a stop at $14. I used the $14 level as the point at which I would no longer believe the trend break to be valid, thus covering the stock and exiting for a loss. The trade did not initially go in the direction I desired. Instead, it moved higher over the next few days, trading as high as $13.92, just three days after I entered the trade. At this point, had I set a fixed stop of 5%, I would have been stopped out as the stock moved against me by 6.25%. After the bounce higher, CBS Corp reversed lower and spent the next several days meandering around my entry price, neither breaking up nor breaking down. After much back and forth, finally on February 3 the stock once again made a surge up, moving as high as 13.85, or 5.7% above my initial short entry At this level, I would have again been stopped out using a fixed 5% stop level. However, because my stop was placed at $14, rather than being stopped, I remained in the trade. After a few days, the stock once again reversed lower, and eventually started showing me a positive return to take partial gains on February 5, when the stock reached a low of $12.42, or 5% below my initial entry point of $13.10. This is a perfect, real-life example of how a dynamic stop kept me in a winning trade, as opposed to a fixed stop knocking me out of the trade before it eventually worked. Placing stops is as artistic as finding the patterns that will give you your edge toward profit. However, just as you identify the opportunity, there must be a corresponding level at which the opportunity is proven a failure and the trade must be removed.
Figure 12.2 CBS Corp breaking below an angular ascending trend.
Chart courtesy of Worden—www.Worden.com.
Reviewing the previous trade strategies, using lateral and angular trend lines as your guide, in addition to the different methodologies anticipatory or reactionary, you should be able to identify the level at which a stop order would be placed for each trade taken.
If you recall from the preceding chapter, the reactionary trader or delayed reactionary trader waits for the desired move to occur before initiating a position. For example, if a lateral or angular trend line has been identified with a trade strategy developed to enter the position on a corresponding break of the trend, a stop strategy is relatively easy. The same trend line that was used to determine the breakout level may also be used as a guide from which to exit the trade.
For the purpose of this example, I have drawn angular and lateral trend lines to discuss the stop point noted in Figure 12.3. For each chart, let’s assume you have identified that the trade would be taken on a trend change rather than on a trend continuation. It is this same line that may then be used as a stop level. At times, a break of trend that reverses may happen the same day, and this is why you might want to wait until the day is nearing a close, and thus ensure the break is holding, before initiating the position. This delayed reactionary style may help to avoid being whipsawed and stopped out the same day. The risk is that you might miss a significant move if the initial break transpires early in the day and continues to move aggressively all throughout the day. In my opinion, you should learn to gauge this based on the environment you are in. If you are continuously missing out on large moves by waiting until the day’s end, clearly an adjustment needs to be made by removing your hesitation.
Figure 12.3 Sample lateral and angular trend lines.
For reactionary traders, the stop is clear and should not be argued with. Setting stops while using an anticipatory strategy is not as simple. Setting stops for anticipatory trades is a bit challenging because you are entering the stock before the trend line you are watching has come into play. Because of this, you must look elsewhere to determine whether your trade is no longer valid. Most of the time, you can do this by finding an alternative trend line on the opposite side of the level you are watching. It does not matter whether the trend line you use to determine your stop is the same type of trend line you are using to determine the trade in the first place. For example, if you are anticipating a lateral trend break, but see a corresponding ascending trend below, you could easily use a move below the ascending trend line as your stop point. However, at times it may be a similar trend line. For example, identifying a lateral trend line above and a lateral trend line below would result in two key levels from which you could determine both the success of the trade and the stop level.
The charts shown in Figure 12.4 and Figure 12.5 illustrate this stop strategy and how it relates to anticipatory trading.
Every trade is different, and, like snowflakes, no two chart patterns are exactly alike. Although putting risk management guidelines in place via stops is essential, it is just as important to correlate your stop strategy with the opportunity that has developed. Doing so ensures that you remain in the trade to at least experience the pattern coming to fruition or see it negated altogether.
Figure 12.4 General Electric consolidating above and below angular trend lines.
Chart courtesy of Worden—www.Worden.com.
Figure 12.5 IBM consolidating above and below lateral trend lines.
Chart courtesy of Worden—www.Worden.com.