Today’s Trading Lesson From TradingMarkets

Brice

Learning From A
Loss

By Dave
Landry

A loss is not
a total loss, as long as something is
learned. Below we will look at a recent trade in Amerisourcebergen (ABC),
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.