The truth about protective stops…
The market had a bit of a selloff
today, but volume is not reading too heavy. As I write this it
appears that the market will avoid another distribution day. So far it doesn’t
seem the selling over the last day and a half is anything to be overly concerned
about. The trend remains up and my focus remains on the long side.
I’ve had several questions lately on the use of stops, so I
thought I would commit a few columns to them. Today I want to talk about initial
protective stops. Many traders consider initial protective stops to be an
absolute necessity when entering a trade. I agree — under certain circumstances.
An initial protective stop is a price point that if the stock
reaches the position will be exited. It is used to protect against suffering
oversized losses in one’s account. These stops can be set using a number of
methods. The most popular are dollar stops, percent stops and technical stops.
Dollar stops say if the stock drops a certain dollar amount
after purchase, the position will be sold. They are popular with day-traders who
frequently trade the same number of shares regardless of the security. Dollar
stops are easy to calculate which is important for hyper-active traders.
Percent stops look to exit the position if it drops more than
a certain percent. Some intermediate-term traders use these to control the
amount of risk they are taking on in any one trade.
Technical stops use technical supports levels identified by
the trader on a chart. These are the protective stops that I always use. The
concept is simple. If the price breaks my support levels, the pattern I used to
purchase the stock will no longer be valid. Therefore, it will be time to exit.
If the nearest technical stop that I want to use is very far away from my buy
point then I will reduce my position size so that I am not taking on more total
risk than I am comfortable with.
Regardless of the method you use to set your initial stops,
the usefulness remains consistent. You don’t want to get hurt too bad by any one
trade. Using an initial protective stop will help prevent this.
So when aren’t initial protective stops appropriate?
There are many ways to control risk. Stops are just one. Here
are a few situations where protective stops may not be needed:
1) In a highly diversified portfolio, where each position only
makes up a very small percent of the total. If the position is only 1% of the
account, your risk is already limited to a 1% portfolio hit. Unless you are a
trend trader, stops may not be a suitable technique for controlling risk.
2) When trading market indices or ETF’s and trying to
anticipate reversals under extreme conditions. Indices tend to oscillate fairly
well. If for instance you decide you want to buy the SPY each time there is a
sharp multi-bar pullback on the chart (pick your time frame — pick your
indicator), you will normally be better off waiting for a bounce to sell into
than you would setting a stop. An individual stock may completely blow-up based
on news, but it is extremely unlikely the whole S&P 500 will.
Best of luck with your trading,
Rob
P.S. As sometimes happens, I have fallen behind on my emails
lately. Please be patient. I will do my best to respond to everyone shortly.
For those who may be looking to expand their
knowledge beyond just market timing, my
Hanna ETF Money Flow System utilizes the VIX in generating trading
signals for spread trades.
Rob Hanna is the principal of a money
management firm located in Massachusetts. He has spent the last several years
developing and refining methods for trading in stocks across multiple time
frames. He selects stocks using both fundamental and technical criteria, and
then trades them using technical analysis techniques.