Friday, November 12, 2010

Stop Loss Selection

How many times were you taken out of a trade just before the stock turns around and takes off in your presumed direction with you as the spring board?  Not pleasant.  So when a friend of mine asked me to help with placing stops I wanted to be clear on the topic since stops are a key risk management skill that traders must have to survive this game.  This article talks specifically about stop losses, not for break even or stop with profits type exits.
The short answer is the same to many trading questions: it depends.  It depends on the style of trading, time frame, risk tolerance, etc.  That’s why system trading is very popular as the trading parameters; entries, exists, stop losses, stops, targets etc, are mostly pre-defined.
So let’s pick a specific scenario/system and take it from there: Swing trading days/weeks hold-time with buying support on signs of strength on the intra-day/daily/weekly/monthly charts review, using close prices.
You are at a point where you have identified your support levels and have your entry area with a good risk/reward ratio selected.  For picking a stop, you have to get familiar with the stock's personality first to see how it behaves around key levels: Look at the history of the stock, does it trade cleanly around key levels or does it violate it before it recovers?   This will help you decide your initial risk, whether to give your stop more room, use a soft or hard stop, or use that stock at all for that matter.  The cleaner the levels the better.
Keep in mind that key levels can also change from day to day when they are an active moving average.  Or when that moving average enters into the trading range of a stock that previously had clearly defined/drawn lines representing key levels, such as channels, breakout levels, etc.
Now that you have your support levels and are more familiar with the stock behavior, you can have a stop that’s lower than the support levels by roughly 0.5-1.5% depending on the price of the stock and how volatile it is.  On shorter term momentum holds, you can enter as close to the low of the day (LOD) as possible with a stop under the LOD.  Breaking the LOD+ and holding there is your signal that there’s more selling to come and the stock is not ready yet to bounce.  In this case either step aside and let the sellers finish their business or if there’s a good short setups play then take the short side of the trade with as many checks in your favor as possible.  Everything that applies for the long side the reverse applies on the short side, just make sure you are going with the trend in the time frame you are trading (many different topics here beyond the scope of this article.)
In addition, keep in mind that you do not have to stop out your entire position at a single level.  You can get out of your position in stages depending on your risk and the strength of the supports.  It does not have to be an all or none type trading depending on your style.
If you have any questions let me know. 
Peace and profits to all,

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