Becoming a Better Trader: Stops
By Quint Tatro Sep 24, 2007 1:00 pm
By watching your underlying positions and adhering to a strict stop loss discipline, you will immediately be selling stock and raising cash when your individual stocks start to break down.
Now that you have a firm grasp of position sizing (Rule #1), you understand how important is to let the chart speak (Rule #2) and you are learning the importance of buying in pieces (Rule #3) it's now time to discuss our trading guardrails, or stops, as they are more commonly referred to. This is an area of heated debate but I am a firm believer in stops as they are yet another effective tool to help you eliminate the emotions that come with trading.
Rather than becoming attached to a stock that isn't working, once a stock crosses a designated area, the stock should be sold and taken off the position sheet. Never do you want to set out with a plan for a trade and alter that plan once it starts going wrong.
I always like to equate trading stocks with dating. First of all, it's important to understand that you are never looking to marry a stock. Sure, you may stay with others longer or become more intimately involved with a few, however you don't ever want to find yourself at the altar saying "for better or for worse" with a stock. It just doesn't make sense. Trading is one of the most humbling activities in the world, and you must know in advance that often you will be wrong. Understanding this and accepting it is half the battle. Stops help to quantify where that area is when you go from possibly being right to absolutely being wrong. When that level is hit, the stock is sold and you move on.
If you missed the beginning of Prof. Tatro's series, Becoming a Better Trader, you can catch up with the preceding columns here: Developing Your Personal Rules, Position Sizing, Let the Chart Be Your Guide and Legging In.
There are many different methods when it comes to stops. Some will set a stop a specific percentage below the purchase price, regardless of the stock or where it is trading. Others will set a firm dollar amount that when lost will trigger a stop. Still others will calculate their maximum portfolio loss for each trade, and set the stop at the level where this would occur in each stock traded.
I, on the other hand, like to let the chart tell me where to set a stop. Over the years, I have learned and have been teaching others how to identify when a stock goes from "acting well" to "acting poorly." Typically the area that separates these two determines my stop. More often than not it is a support level as determined by a previous bottom, a trend line or moving average. Rather than set such a rigid rule, I like to set my stops on a case-by-case basis, giving each position enough room to either act appropriately or break down. Furthermore, because I always buy in pieces (Rule #3), I will typically give a partial position more room so I won't be shaken out should it be going through a normal but large draw. By starting with a partial position, this helps to keep the overall P&L in check in the event a healthy retracement occurs.
Once I have identified my stop level I do not change it. Yes, over time, should the stock work, I will raise my stop and trail the stock in order to ensure a winning trade does not turn into a losing trade, but when a stock doesn't go my way, never will I reset a stop to justify a losing trade.
Once my stock has been identified, and my partial position has been taken, the stop is determined and I am now "in the trade." The only differentiating rule I have adopted through trial and error over the years, which is quite different than most, is I will almost always give my stock the entire day to recapture its stop level in the event it has breached my stop, unless there has been a material change within the company.
As I was developing as a trader I noticed that so often after I took my stop the stock would go on to bounce and recapture the level at which I would not have sold by day's end. I cannot prove why this happens, but I have my theories, What I do know is that my own back tested trading reveals an overwhelming conclusion that had I given the stock the entire day, I would have remained in the trade rather than being stopped out. So rather than adhere to firm stops by actually setting orders, I will go through each position close to the end of the day and determine what needs to be cut and what can stay.
My only exception to this rule as mentioned above, is when a material change sets in to affect the company. This would be something like an earnings report, a management change, lost contract etc. Once I have determined that a reaction is unfavorable to this material change, and my stop area has been breached, I will typically cut the position and move on regardless of what time a day it is.
One of the questions I receive often when we go through a poor market environment is how I was able to sidestep much of the carnage. My answer is quite simple. Markets don't get terrible over night. They typically start to act poorly before the real selling kicks in.
By watching your underlying positions and adhering to a strict stop loss discipline, you will immediately be selling stock and raising cash when your individual stocks start to break down. When this happens, my stocks are cut and very quickly my cash level starts to grow. As the market continues to wane one by one my stocks are cut as they cross their lines of technical health and most of the time, I have raised cash taking only small losses while sidestepping the true carnage that is coming. You see, most people who suffer significant losses do not cut stocks quickly. Rather they adhere to the buy and hold mentality and ride the stock all the way down for a terrible loss. Finally, when the stock is done going down and becomes lifeless, the trader decides to cut the stock and is now faced with a very large loss to make up. These losses are very hard to recover from and often significantly damage not only the trader's financial capital but emotional capital as well.
Rather than fall into this trap, adhere to a basic stop loss rule and save yourself the headache.
No positions in stocks mentioned.
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