| It is virtually a "law" of trading in the stock market that | | | | month or more to lock in gains of 10% to 20% or even |
| wherever you place your stop loss, it will occasionally | | | | more. However, you may have to loosen the stop a |
| be triggered by a stock just before it resumes its climb | | | | little for more volatile stocks and for regular holding |
| to higher levels. That is just something to be | | | | periods of more than 15 days. For longer-term |
| expected if you use any stop-loss. Unfortunately, not | | | | investing, for example, a stop that is up to 6% below |
| using a stop-loss is asking for trouble of a much | | | | the highest low reached by the stock since it was |
| greater magnitude, and the market loves to reward | | | | purchased can be very effective. A stop that one L |
| the foolish, lazy, or stupid, with the just recompense of | | | | trader experimented with and found to be very useful |
| their behavior. It makes no difference if you set the | | | | for intermediate-term trading is one that is set 4% |
| stop at 10% or at 3% from the low, high, or close. | | | | below the highest low. In use, it was infrequently |
| You can use stops that are volatility-based, use | | | | triggered by a whipsaw and it did not give up much of |
| Fibonacci retracement ratios, Gann analysis, pivot | | | | the gain of the bigger moves. However, it would also |
| points, percentage declines, or any other approach. | | | | give up 4% or more of the smaller 8% moves. That |
| No matter how sophisticated your mathematics is, you | | | | is why some traders focus on stops of 3% or less |
| will often find you have sold for no good reason other | | | | below the highest low. The tradeoff was the greater |
| than the occurrence of a temporary price spike that | | | | frequency with which a person is needlessly stopped |
| was just sufficient to trigger a stop loss -- your stop | | | | out of a rising stock. It would be best if you worked |
| loss. Learn to live with it | | | | out a personal stop-loss system, one with which you |
| On the other hand, you can control risk and have | | | | can be comfortable. |
| some say about the probable frequency with which | | | | If you want a reference point other than the highest |
| you will be ejected from a position because of such a | | | | low, the following may be of help. A test of all the |
| spike. The further your stop is from recent price | | | | stocks in The Valuator showed that the average low |
| action, the less likely it is that it will be triggered. | | | | was 1.7466% below the average high and .882% |
| However, the further your stop is from the price action, | | | | below the average close. This information can be |
| the more risk (downside price excursion) you are going | | | | used to place the stop relative to the highest high or |
| to have to tolerate. Not using a stop at all means you | | | | highest close of the stock since its purchase. Thus, if |
| are willing to accept unlimited risk. Using a "tight" stop | | | | the stock spikes up, the stop will lock in more of the |
| means you are willing to tolerate very little risk but you | | | | gain. This works best when the stock makes a |
| dramatically increase the chances that even a minor | | | | series of new highs, each significantly higher than the |
| spike will eject you from the position. The tighter your | | | | previous one. However, a 1-day spike may cause |
| stop, the more ejection-causing spikes will occur in any | | | | you to be stopped out the following day if the stock |
| given time period. The only way to resolve this | | | | quickly returns to more "normal" levels. Walk away |
| dilemma is to find the best tradeoff between an | | | | from stocks that often spike down. The specialist |
| acceptable frequency of unnecessary ejections and | | | | may simply like to "gun" the stock in order to take out |
| an acceptable amount of loss that you incur because | | | | the stop-loss orders waiting at the lower prices. That |
| of that ejection. In other words, you must find the | | | | is, the specialist temporarily drops the stock price to |
| compromise that induces the least amount of pain | | | | trigger the sell orders associated with the stops so he |
| (psychological or financial). | | | | can buy those shares at the lower price and sell |
| Magee and Edwards (Technical Analysis of Stock | | | | almost immediately afterwards at a slightly higher |
| Trends) teach that a good stop based on closing | | | | price. When considering the purchase of a stock that |
| prices is one that is placed 3% below a rising | | | | often spikes down, the trader should try to place the |
| trendline. The stop is triggered only if the stock | | | | stop just outside the specialist's spiking comfort zone. |
| closes at or below the stop. However, if a trader | | | | If such a placement requires the assumption of too |
| intends to sell on the basis of intra-day price activity | | | | much risk, find another stock. I prefer to concentrate |
| rather than on the basis of closing prices, they suggest | | | | on stocks that rarely spike. Look at charts and notice |
| that the stop be placed 6% below the rising trendline. | | | | the length and frequency of downward spikes. Try |
| Below the trendline or below the most recent minor dip | | | | to determine the percentage drop these spikes |
| is usually the best place for a stop. However, | | | | represent. |
| sometimes there is no trendline or obvious recent | | | | A volatility-adjusted stop has a more universal |
| minor dip. That is when you must use a mathematical | | | | application than a simple percentage stop because in |
| stop. Either a simple percentage based on the | | | | addition to adjusting for volatility it also adapts to the |
| highest high, low, or close since you purchased, or a | | | | time period of the particular "analysis unit" used |
| volatility-adjusted variable stop placed relative to the | | | | (15-minute price bars, 30-minute price bars, daily price |
| highest high, low, or close since you purchased will | | | | bars, and so on). Rigid percentages cannot do either, |
| serve the purpose. Magee and Edwards, Weinstein, | | | | but they are easier for the non-mathematician to |
| Schwager, Murphy, and many others use trendlines, | | | | calculate. If you are trying to compute your own |
| dips, or moving averages as a reference for placing a | | | | stop-losses and you do not have a mathematical |
| stop. Rising trendlines follow the lows, dips are | | | | background, you might do well to use a stop loss |
| nothing more than significant recent lows, and moving | | | | calculating tool (do a Google search on "stop loss tool" |
| averages generally follow a rising stock somewhat | | | | and follow the trail) or simply make appropriate |
| below its recent lows. Therefore, it also makes | | | | modifications to the 2.3% rule. That is, if your stops |
| sense, in the absence of all of these, to use the recent | | | | are triggered too frequently before upward moves |
| highest low as a reference for placing stops. With no | | | | complete when you follow the 2.3% rule, change it to a |
| trendline or dip to use as a reference, you could simply | | | | 3%, 4%, or whatever. However, we believe the |
| place your trailing stop 3% or 6% (or some other | | | | volatility-adjusted stop loss is not only more |
| distance) below a moving average that closely follows | | | | sophisticated but also more effective. Now, consider |
| the trends of significance to you, or even below the | | | | the following. |
| highest low achieved by the stock since your | | | | The stop is not necessarily your sell discipline. |
| purchase. | | | | However, it is definitely your safety net. It will |
| The anticipated average holding period has a very big | | | | preserve assets if you are not paying attention to your |
| impact on how tight your stops are going to be. For | | | | stock's behavior during the day. If you do not have |
| example, the "sweet spot" for the 2.3% rule is about 10 | | | | time to be riveted to the etchings the stock market |
| to 15 market days. The short end of the | | | | makes across your computer's screen, you only need |
| "swing-trader" spectrum is about 3 days or less (a | | | | to take about 10 minutes to go through your positions |
| large number of traders focus on holding periods of up | | | | once a day (even while the market is closed) or once |
| to about one week) and the long end of the spectrum | | | | a week (even on weekends) to set your stops. |
| is 8 to perhaps 10 weeks. The remaining swing | | | | Then you can ignore the market until you make your |
| traders focus on the time frames in between. At the | | | | next stop adjustments. However, if you happen to |
| very short end, the 2.3% rule allows too much of a | | | | be watching your stock and it does not "behave" like it |
| decline relative to the expected gain. However, it | | | | should, simply remove the stop and sell the stock. |
| works well when you are trying to lock in a two-week | | | | Copyright 2009, by Stock Disciplines, LLC. a.k.a. |
| move involving a 4% to 10% gain. If the stock is not | | | | StockDisciplines. |
| too "wild," it will also work beautifully for moves of a | | | | |