Initial Thoughts To Another Trader (Part 2) – Stops
Posted by lasertrader on August 14, 2011
I had several requests to continue to share the email exchanges I am having with another young trader. Tonight I was asked asked to share some thoughts on stops. This post is being written at a time of extreme volatility on the market. Here is what I wrote..I hope it provides some food for thought.
Hello My Friend:
The most important thing you just said is that you are not in a hurry to trade this market. Thats the right attitude. The volatility is nuts and the probabilities are against you. There is no good trade at the moment. I read a lot of twitter just to get a feel for what the masses are thinking. I am bothered that so many are looking for a continued bounce up to the breakdown point. The market is designed to hurt the most and although the technical thing to do is to test that breakdown point I am not convinced it will be that easy. There are bear flags everywhere. Bottom line, step aside and be very careful.
For fun I would like you to read a blog post. The twitter stream is full of young guns with great tactics but sometimes the old guys who have been around a long time can provide some food for thought. Peter Brandt is one of those guys http://peterlbrandt.com/smorgasbord/
Ahhh stops, now thats a topic that you can talk about forever because there are so many ways to do stops. For now i suggest you take a conservative approach to looking at this topic. The best way to do this is to work on proper position sizing. Before you put your position on you need to make sure it is sized properly. From that exercise you can determine the stop. Remember, all that matters is your account balance so you need to manage your risk by figuring out how much of your portfolio balance you are going to risk on a particular trade. This market is in the red zone as far as risk so I wont try to talk about these conditions, but given a more normal market you may decide that you are willing to risk .5% up to 2% of your portfolio on a given trade. >5% and 1% are usually good numbers to use and when the market is trending strongly you could even go up to 2% (for the 2% there is more to consider which I will talk about in a bit).
I am goig to make this simple and as you start working on it you may adjust it to better fit your style and tolerance. Ideally, you are buying a stock when it has started a move up. You can immediately set a stop at one of two places. The first and more agressive would be at the day’s low. The second and more relaxed would be the previous days low.
So…when you put on a trade you need to figure out how many shares to buy so that if you are stopped out you will only lose the .5% or 1% that you had planned. These percentages are for the momentum stock trading style that I trade. Its funny becaue you will often see people quoting stop out at 5% or 6%, well if you put your whole portfolio into that position and you lose 5% you will be hard pressed to recover quickly.
Now lets talk about the 2% risk in a more trending market. The reason you would risk up to 2% is that you want to maximize your gains in a strong trend. Remeber the risk drives your position size so a larger position will pay off better in a strong market. In a 1-2% risk market your swings would and should end up being more than 2 to 3 days, they could be weeks if you are lucky. With this in mind I would only put half the position size on with the first buy and perhaps add more the next day as it shows it will continue strongly.
Now, once you are in a position you need to figure out where your stop should be. It could be the previous days low, the 2 day low, break even, or at a support level. I wish I could be more specific but it really depends on the stock and the chart. There is also a whole discussion on Average True Range (ATR) for the stock you are trading and using a 1.5 or 2 ATR as a stop.
I think you were more concerned about the stop on the initial position and I think I have given you some guidelines to think about. Once you are in a profitable position it will really depend on the action, how many positions you have on etc. Just keep in mind my two main points. Your goal is to increase your account and there is always another setup. I often sell too early but I wont look back because I have more opportunities than I can usually handle. Lately am trying to work on holding longer and have that as my main effort for the forseeable future.
You also asked about some of the mechanics of stops. You should use a stop/market order. Yes, there is always going to be slippage and you may end up selling quite a bit further below your stop but if you use a stop/limit the odds are you will not get exercised because price will keep going down and not come back up to your limit. You realize that a stop limit says trigger at the limit price first, then execute at that limit price or above. Usually the stop gets triggered at the limit price and the next trade and all that follow are below and you never get executed.
One of the nice parts of Thinkorswim charts is that your standing orders are shown on the charts. If you are watching your positions you will pretty much be able to judge in advance the action and pull your position manually even before your stop if it looks like death on the doorstep.
Here is another thing to watch out for. When I swing trade I never have my stops enabled at the open. Quite often I would not enable them until 5 or 10 minutes later. The first reason is that there are often some unusual spikes at the open that will take you out and then the stock pops right back up. Second, if there is a gap down there is usually a bounce within the first 30 minutes or even first 10 minutes back up to where you would have stopped out or even back to green. Be careful to avoid the opening nonsense and dont panic with the masses.
This should get you thinking. We can further this conversation as you would like. Just ask.