Learning From A Loss

A loss is not a total loss, as long as something is learned. Below we will look at a recent trade in Amerisourcebergen (ABC | Quote | Chart | News | PowerRating), and what I learned, or more accurately, re-learned.

The Setup

First let's look at the setup. The stock makes a big picture double top around 72 and begins to sell off. The moving averages roll over and on 11/06/01 the stock sets up as a Bow Tie (a). The entry for this pattern is below the low of the current bar (for the next day) and the protective stop would be above the high the setup bar. This gives me an entry of 62.65 and a protective stop of 64.05.

On the next day, the stock triggers the entry (a) but unfortunately quickly stops me out (b). I lick my wounds and move on.

On the following day, to add insult to injury, the stock implodes (a) -- trading nearly 6 points lower.

To further add to my aggravation, the stock continues to implode on the following day. At its lows (a), it was down nearly 9 points from my original entry.

Post Mortem

What can be learned from this losing trade? Plenty:

Stop Was Too Tight

In my article The Myth Of Tight Stops, I discuss the fact that tight stops can often lead to more losses because the normal noise alone of the market can stop you out. This "noise" can be measured by analyzing the volatility of the stock.

Volatility can be analyzed in several ways. First, the price of the stock, in general, determines how easily the stock can move on a point basis. Said another way, higher-priced stocks tend to fluctuate more on a point basis than lower-priced stocks. For instance, a 5% move a $100 stock is 5 points, whereas a 5% move in a $20 stock is only 1 point. Based on this alone, as a personal rule (for swing trades), I normally use a protective stop of at least 2 points on stocks priced $50 or higher. In this case, I think I simply overlooked the fact that my stop was less than 2 points.

Another way of analyzing the volatility of a stock and where it might trade over a holding period is to use historical volatility.* Based on a possible 5-day holding period, a historical volatility based stop would have to be placed at 66.57 (circled below) to avoid the normal noise of the market. Although one might not want to place a stop that far away, it illustrates that anything less than this could be within the "normal" noise based on this measurement.

Volatility can also be measured by using the average true range of the stock. Notice below that the 5-day average true range in the days leading up to the trade was well over 2 points. This suggests that a stop within 2 points has a good chance of being hit.

My favorite way to measure volatility is to simply "eyeball" a stock. This means simply looking at the chart for a rough estimate of volatility and daily range. Notice below that as the stock began to break down from the double top it formed wide range bars (WRB) and gapped lower. This action suggested that the volatility was increasing. Also notice that on many days, the range of the stock was at least 2 points (72-70, 68-66,64-61 etc...). Therefore, a stop placed less than 2 points from the entry would have a good chance of being hit.

Based on the volatility analysis, it's now clear that my stop was too tight. This is not to imply that tight stops cannot be used. There's nothing wrong with using a tight stop and taking another "stab" at a stock if stopped out. This brings us to my next lesson learned.

Forgot About The Stock

As traders, we are taught to quickly forget about losses and move on. However, because the market does not always fit neatly into our time frame, sometimes the best trade is a second entry after a failed attempt. When I first found this setup, I remember thinking that this stock was in serious trouble. It had formed a big picture double top which was confirmed by the stock rolling over and setting up as a Bow Tie. I "knew" in my gut that it had the potential to make a large move. However, after getting stopped out, I forgot these things and began looking for other opportunities.

In Conclusion

In this example, I failed to properly analyze the volatility when placing my stop. Further, I missed an opportunity by losing sight of the big picture.

After taking a loss, analyze the stock. Remember a loss is not a total loss, as long as something is learned.

*Source: Connors On Advanced Trading. It is also discussed in my article: The Myth Of Tight Stops.

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