The Great Mystery of Stops
One of the great mysteries of trading is the subject of the dreadful stop. It is the number one question that I get from clients, “what kind of stops should I use?”
My philosophy regarding stops is very different than most people .when PEOPLE learn how to use them wisely, they discover that stops don’t have to hurt.
Stops are the medicine of trading.
When your trade is sick, stops are there to heal it.
There a few ways of using stops:
1. The “No Stop” –
What do you call a trader that doesn’t use stops? An investor. When a trader lets a trade go against him, he gets married to the stock, starts looking at fundamentals and becomes an investor. I have seen many people, especially in the early 2000’s, buy a stock at 120 and still hold it today, even though it’s a penny stock today.
2. The “random stop” or the “gambling stop” –
These happen when a trader knows how much money he wants to risk on a stock, his “bet” on the stock, and that is his stop. Buy XYZ stock with a $500 dollar stop, because that is all they can allocate for this trade. These traders think of their trading as gambling, they put in their money on the table and forget about it.
The problem with this method is that it is not a method, there is no reasoning behind the placement of the stop.
3. The “Adding in stop” –
Some traders keep adding in money into their position as it goes against them. This is also called “Dollar Cost Averaging”.
When I was a stock broker, guilty as charged, we were taught that adding money to a position lowers your cost on it and, therefore, allows you to buy more shares at a lower price. Mr. Investor, if you liked XYZ at 50, I am sure you will like it so much more at 40, right?
The reasoning behind this method is very dangerous.
You buy 1000 shares at 40, buy another 1000 at 39, buy another 1000 at 38. Now, your average cost is 39, not 40 as you originally wanted. The stock only has to jump up a dollar for you to break even, not two dollars.
The problem comes when the stock keeps diving and you are now stuck with 3000 shares on the wrong side of a breakout.
I have seen many ex-traders use this method to wipe out their accounts. This trader will become an investor. If not on the first 20 trades, then on the 21st that would wipe them out.
It only takes one large loss to devastate an account and devastate the trader.
Stops are like medicine for your trading.
The longer you take before you swallow the bitter pill, the worse your condition is going to be.
Preventive medicine works so much better, it prevents small weaknesses from becoming serious diseases.
Our method of stops is very simple, always exit a trade when the reason for your entry no longer exists.
Notice I said exit, not stop.
We do not take stops, we exit.
Sometimes it’s a negative exit, but it is still an exit, not a stop.
A “stop loss” stops your loss, we are not interested in the trade becoming a loss.
If you have done your analysis right, you should be able to pinpoint an entry.
An entry is a trigger that starts a trend,
starts a wave in a trend,
starts a bounce,
starts a fade or a break out.
If you are accurate with your entry, then your exit should be very simple.
If you entered a trend, you exit when you know that the reason for your entry no longer exists, when the stock refuses to start your trend.
If you entered a breakout, you know the reason for your entry no longer exists when the stock returns back into your consolidation.
So how much is that?
Your stop, or negative exit, (if you did your home work and pinpointed your entry,) is Noise + Spread.
Noise is the normal fluctuation of the stock and spread is the difference between bid and ask.
Basically, if you add them together, it is the amount that the stock can pull back before you know that your entry is wrong.
For example, in day trading, most of our negative exits are less than 5 cents. Most of the stocks that we trade have less than 5 cents spread and noise. In Swing trading, most of our negative exits are less than 50 cents for the same reason.
Some people day trade with a dollar stop or even two dollars. If you do your home work and can pinpoint your entry, how many 5 cents negative exits can you take before you equal one point or two points?
Imagine having 20-40 attempts for the price of one.
There are three keys to success here:
1. Pinpoint your entry – You need to know exactly where to enter.
2. Know exactly where the reason for your entry no longer exists –Where on the chart does price have to go to invalidate your entry?
3. Re-entry – If the stock comes back and your setup is still valid, make sure that you re-enter.
Most of us pay less than $10 in commissions, which is a lot less than a devastating stop loss of multiple points.
If you have to pay $10 plus pennies for a trade that didn’t work, it is a business expense, not a stop loss. It protects you financially and psychologically. It allows you to re-enter the trade without any damages.
If you exit with an expense of $100, it will do a lot less damage than several thousands or your whole account. How would you feel if you spent a hundred bucks on a trade vs. lost several thousands on a gamble?
Traders need to get educated how to pinpoint their entries and know exactly when the trade is working or not, in order to keep stops down to business expenses, instead of serious losses.
The secret to longevity and prosperity in trading is knowing why you are entering, pinpointing your entries and preservation of your capital.
Preservation of capital is always more important than capital appreciation.
Hope this helps your trading in some way.
Dedicated to maximizing your profits,