Using protective stops is essential for your survival and long-term success. One of the main reasons so many traders lose and wash out of the markets is that they don’t use stops. We like thinking about profits, but you’ve got to know what is the maximum amount you can lose in a trade. Without that limit, you can irreparably damage your account.
People don’t use stops for three reasons: ignorance, wanting to hang on to hope, and the trouble with whipsaws.
As you approach the end of this book, ignorance should no longer be an issue. You know better than to waste money hoping that a sinking stock will miraculously reverse and rally. Whipsaws, on the other hand, are a real problem.
A whipsaw means that you buy a stock, set a stop underneath, the stock declines and hits it; you exit with a loss, only to see your stock reverse and rally just as you originally expected. After several whipsaws many folks give up using stops. But trading without stops is a recipe for a disaster because sooner or later, one of your ‘stopless’ stocks will get caught in a major downdraft and deliver a ‘shark bite’ to your account. Even though we can never completely eliminate whipsaws, we do have ways of reducing their occurrences.
Stops are a pain – but a disciplined trader accepts that pain just like a professional athlete accepts the pain of never-ending workouts. What we need to do is make our stops more logical and less likely to be hit by random moves. This will reduce the frequency of whipsaws. That’s what discipline is about: you put your hand out where it can be slapped, but you do it on your terms. An undisciplined trader spares himself the occasional slaps of whipsaws, but loses his arm to a shark bite of a disastrous loss.
There are chapters on various ways of setting stops in my books The New Trading for a Living and The New Sell and Sell Short. Let me condense them into two essential principles.
One: don’t place your stops at obvious levels. Crowds of lazy and unimaginative traders plop their stops immediately underneath recent lows. The market often sinks back to those obvious lows, triggers their stops, then reverses and rallies again. That’s why false breakouts, which we’ve discussed, are so common in the markets.
Place your stops at non-obvious levels – either closer to the market or deeper below the low. A closer stop will reduce your dollar risk per share but increase the risk of a whipsaw. A deeper stop will help you sidestep some false breakouts, but if it gets hit you’ll lose more. For short-term swing trading, it generally pays to place your stops tighter, while for longer-term position trades you’d be better off with wider stops. Remember ‘the iron triangle of risk control’ – a wider stop will force you to trade a smaller size.
Two: be sure to measure your stock’s volatility in deciding where to place your stop. A very practical tool is ATR (Average True Range). This indicator shows what distance your stock is likely to cover from one day to the next. There is an article on ATR in StockCharts’ ChartSchool and a chapter in my book The New Trading for a Living.
StockCharts makes it easy to look up the current ATR value. Create a new SharpChart and then find the “Indicators” area below the chart. Click on one of the unused dropdowns (“-None-“) and select “Avg. True Range (ATR)” from the list that appears. (I also like to change the Parameter setting from “14” to “26” but that depends on your time frame.) Finally, click “Update.” You’ll see a curve that rises and falls with your stock’s volatility. The number at the right edge is the current ATR value.
You definitely want to put your stop more than one ATR below your entry point. One ATR is the normal range of market noise, and if you jam your stop any closer, you’ll be asking for a whipsaw.
One and a half ATR is the minimum distance from the entry to stop, two ATR even better. The farther away your stop, the lower your risk of a whipsaw but the higher your dollar risk per share. That’s where the Iron Triangle of Risk Control comes in, reducing the permitted number of shares when your risk per share increases. This way you can keep your total risk per trade within a predetermined limit.
As for the profit targets, use value zone and channel lines, as shown repeatedly in previous chapters. If you buy at a certain distance below the value zone and catch an uptrend, expect the pendulum of the market to swing a similar distance above value. If your analysis is strongly bullish, make the upper channel line your profit target.
Your visual diary
As we approach the end of this book, I’d like to return to the theme with which we began our journey. Being mindful and keeping good records will help you become a successful trader. This is why it is essential to keep a diary of your trades, documenting your entries and exits and reviewing those charts to learn what you did right or wrong.
There are many ways of keeping a visual diary, and StockCharts allows you to draw and write notes on your charts, then save them for future review. You can create a folder, call it My Trades, and put those saved charts into it. Name them using the ticker, date and action, for example AAPL_20150126_Entry or FB_20150128_Exit.
Let’s return to the very first stock we looked at in this book, whose numerical record appeared in Figure 02. Now, here’s the diary of my AMT swing trade. I made my strategic decision to buy on a weekly chart and tactical decisions to enter and exit on the daily charts. I exited this trade in two steps, a day apart.
Planned entry was $92.52, target $97, stop-loss $91.12 (reward-to-risk ration of 3.2). Note that I entered before the weekly Impulse turned blue. I did it because the daily signals looked perfect and the stock was moving in the right direction, protected by a stop.
People don’t use stops for three reasons: ignorance, wanting to hang on to hope, and the trouble with whipsaws.
As you approach the end of this book, ignorance should no longer be an issue. You know better than to waste money hoping that a sinking stock will miraculously reverse and rally. Whipsaws, on the other hand, are a real problem.
A whipsaw means that you buy a stock, set a stop underneath, the stock declines and hits it; you exit with a loss, only to see your stock reverse and rally just as you originally expected. After several whipsaws many folks give up using stops. But trading without stops is a recipe for a disaster because sooner or later, one of your ‘stopless’ stocks will get caught in a major downdraft and deliver a ‘shark bite’ to your account. Even though we can never completely eliminate whipsaws, we do have ways of reducing their occurrences.
Stops are a pain – but a disciplined trader accepts that pain just like a professional athlete accepts the pain of never-ending workouts. What we need to do is make our stops more logical and less likely to be hit by random moves. This will reduce the frequency of whipsaws. That’s what discipline is about: you put your hand out where it can be slapped, but you do it on your terms. An undisciplined trader spares himself the occasional slaps of whipsaws, but loses his arm to a shark bite of a disastrous loss.
There are chapters on various ways of setting stops in my books The New Trading for a Living and The New Sell and Sell Short. Let me condense them into two essential principles.
One: don’t place your stops at obvious levels. Crowds of lazy and unimaginative traders plop their stops immediately underneath recent lows. The market often sinks back to those obvious lows, triggers their stops, then reverses and rallies again. That’s why false breakouts, which we’ve discussed, are so common in the markets.
Place your stops at non-obvious levels – either closer to the market or deeper below the low. A closer stop will reduce your dollar risk per share but increase the risk of a whipsaw. A deeper stop will help you sidestep some false breakouts, but if it gets hit you’ll lose more. For short-term swing trading, it generally pays to place your stops tighter, while for longer-term position trades you’d be better off with wider stops. Remember ‘the iron triangle of risk control’ – a wider stop will force you to trade a smaller size.
Two: be sure to measure your stock’s volatility in deciding where to place your stop. A very practical tool is ATR (Average True Range). This indicator shows what distance your stock is likely to cover from one day to the next. There is an article on ATR in StockCharts’ ChartSchool and a chapter in my book The New Trading for a Living.
StockCharts makes it easy to look up the current ATR value. Create a new SharpChart and then find the “Indicators” area below the chart. Click on one of the unused dropdowns (“-None-“) and select “Avg. True Range (ATR)” from the list that appears. (I also like to change the Parameter setting from “14” to “26” but that depends on your time frame.) Finally, click “Update.” You’ll see a curve that rises and falls with your stock’s volatility. The number at the right edge is the current ATR value.
You definitely want to put your stop more than one ATR below your entry point. One ATR is the normal range of market noise, and if you jam your stop any closer, you’ll be asking for a whipsaw.
One and a half ATR is the minimum distance from the entry to stop, two ATR even better. The farther away your stop, the lower your risk of a whipsaw but the higher your dollar risk per share. That’s where the Iron Triangle of Risk Control comes in, reducing the permitted number of shares when your risk per share increases. This way you can keep your total risk per trade within a predetermined limit.
As for the profit targets, use value zone and channel lines, as shown repeatedly in previous chapters. If you buy at a certain distance below the value zone and catch an uptrend, expect the pendulum of the market to swing a similar distance above value. If your analysis is strongly bullish, make the upper channel line your profit target.
Your visual diary
As we approach the end of this book, I’d like to return to the theme with which we began our journey. Being mindful and keeping good records will help you become a successful trader. This is why it is essential to keep a diary of your trades, documenting your entries and exits and reviewing those charts to learn what you did right or wrong.
There are many ways of keeping a visual diary, and StockCharts allows you to draw and write notes on your charts, then save them for future review. You can create a folder, call it My Trades, and put those saved charts into it. Name them using the ticker, date and action, for example AAPL_20150126_Entry or FB_20150128_Exit.
Let’s return to the very first stock we looked at in this book, whose numerical record appeared in Figure 02. Now, here’s the diary of my AMT swing trade. I made my strategic decision to buy on a weekly chart and tactical decisions to enter and exit on the daily charts. I exited this trade in two steps, a day apart.
Planned entry was $92.52, target $97, stop-loss $91.12 (reward-to-risk ration of 3.2). Note that I entered before the weekly Impulse turned blue. I did it because the daily signals looked perfect and the stock was moving in the right direction, protected by a stop.
I exited this trade in two steps: first half on the third day and the rest on the fourth, as prices seemed to stall near their recent top. I bought below value and sold above the value zone in a swing trade that earned several thousand dollars (see Figure 02), without too much exposure to the markets. The next time I see this pattern, I’ll do exactly the same thing.
I’m writing several months after closing my AMT trade. Do you think that without these charts I could remember any details? No, of course not – but my records enable me to go back in time and see everything as fresh as it was on the day I traded. I can review my decisions and learn from my actions. A trader who keeps good records becomes his own teacher. You cannot buy that – but you can get it for free, with your own labor.
The road ahead
Trading is a never-ending journey. It offers great rewards, but demands focus, attention, and discipline. It is also a huge amount of fun – especially when you do it right. I enjoyed creating this book, and hope that you enjoyed our journey together.
You, as a StockCharts user, have a great tool at your fingertips, with many more features than we covered in this book. Explore them, use them, but don’t get carried away. There is less to trading than meets the eye, and you need a system that is relatively simple and robust.
There are several excellent market analysts associated with StockCharts. As a Member, you’ll be receiving their emails. Select one or two you especially like and read their posts on a regular basis.
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