How To Set Stops
I’ve
had several emails recently from TradingMarkets’ members regarding
stop placements and risk management, so I thought I’d share some thoughts with
you all on the topic of setting initial protective stops.
Initial stops are commonly set using percentages, points, or technical support
levels. It doesn’t matter how you set them. To be effective, they must be close
enough so that risk is contained to an amount that you are comfortable with, and
far enough away that the trade is given room enough to work. How you set them
and when you raise the stop is a personal decision. These decisions should be
based on your own comfort levels and personality.
For example, when I set my
initial stop, I normally use technical support levels. I do this because if the
stock breaks below those levels, that is a signal to me that the trade simply
did not work. The setup failed. The technical picture I liked when I bought it
has now changed, and therefore it is time to sell.
Other people may be
convinced their trade has failed if the stock drops more than $0.50, or more
than 8%, or below a moving average. Whatever guideline you like to use is
fine. The important thing is that you understand a move below your stop level
is a signal that the setup failed and the trade needs to be exited. If you’re
not truly convinced of this, you will forever be 2nd guessing your
decisions to exit the trade.
“Shoot, the stock bounced right
back up after I sold it and I would have a huge gain right now. I should have
stayed in the trade.†Wrong. Just because the stock moved back up doesn’t mean
you made the wrong decision.
In Blackjack, when a player is dealt two tens, and the dealer is showing a six,
that player should stand. Twenty is an excellent hand. The chances
of the dealer beating a 20 are very small. Also, the only card a player
could possibly pull that could help his hand is an ace. Any other card
would bust his hand and make him a loser. So the obvious play is to stand.
Now, if the dealer turns over his hole card and it is a four, and then the
dealer draws an ace to make 21 and beat the player, that’s just tough luck.
No blackjack player in their right mind would say “Nuts. I messed up.
I should have taken a hit. Then I would have drawn an ace and won the
hand. Next time I’m going to take a card when I have a twenty and the
dealer is showing six.†It’s understood that the right play was made and
the player lost anyway. Ninety-five times out of a hundred, that player
wins the hand. Second guessing himself and changing his strategy is the
wrong play.
It’s the same with trading. By
having a valid reason for setting a stop at a certain level, and believing that
a violation of that stop indicates a failure on the part of the stock, you will
better comprehend that selling the stock when the stop was violated was the
RIGHT thing to do. It doesn’t matter what the stock does AFTER you sell it.
Many stocks WILL stop you out and then move higher. No one is right on every
trade. Make the play your supposed to make and take comfort in the fact that
over the long haul, you’ll do much better by being consistent with your trade
management.
Trading is a game of
percentages. Find a method of setting protective stops that you’re comfortable
with, and stick to it. As long as you’re containing your risk to a reasonable
amount, and at the same time giving the trade a chance to work, you should be
fine.
As far as the market goes, the
indices sold off a bit today on lighter volume. This does nothing to change the
market outlook, in my opinion. I’m still trading with a bullish bias, but
keeping a close eye on distribution and the action of leading stocks. There are
a few yellow flags as far as distribution days recently, but nothing
overwhelming just yet.
Best of luck with your trading,
robhanna@rcn.com