Morning Market Thoughts…on Stops

Good Morning. Yet again….stocks are set to open flat, with a slight upside bias. The longer stocks stay at current levels, the more likely it is that the next move will be higher. All we need is a catalyst.

During the training session yesterday, I discussed the use of stops. Some key aspects of that conversation are:

Use stops to protect your initial trading capital — when you first enter a position, you are at the greatest risk of losing money. Based on your research and chart studies, you believe that you are correct in buying a stock…but you’re not sure. You’re starting from scratch, and only when the stock advances in price will you have confirmation that you are on the right side of the trade. So, until that happens, you’ve got to define exactly how much money you are willing to risk in order to have a chance to make money. The sky is the limit, right? But if you don’t use a stop loss order, then the basement’s the limit. You put yourself at risk of losing a significant portion of your trading capital because, once in the trade, you can lose objectivity. You are IN the trade, so you have a personal stake in it. Nobody wants to be wrong. And nobody wants to lose money.

So once you are in the trade, your ego and your money are at risk. So if the stock starts to move against you, your ego tells you that you are not wrong; you’re just “early.” And as the stock continues to fall, your anxiety grows and your objectivity makes a very fast exit. At some point, you realize you are not “early”; you are wrong. But the problem is that you are losing more money than you envisioned, and you can’t bear to take that loss. So you hold the deteriorating position while hoping that the stock turns around and allows you to lose less money. You’ve given up on profits; you just want a portion of your money back. To sell right now risks being wrong because you fear that the stock will rebound immediately after you’ve sold. Bam! You’re wrong again! One big loser…but twice wrong!

When you place a stop on your position as soon as you open it, then you have defined your maximum acceptable loss. Your worst case scenario is ok…because you got to decide what it is. And you make that decision based on position size (i.e., not the amount of shares bought; but the amount of money that is in the trade), and on the distance between your entry and your stop loss level.

Because you do not want to put much money at risk when you are initiating a trade, your stop will be fairly limiting in your maximum risk — perhaps 3-5%…rarely more than that. And your position will be only a fraction of the position size that you’d like to hold. You intend to take a full position on the stock — say, 5-10% of your portfolio size. But you aren’t gonna do that right now, when you are at maximum risk of losing money. Remember, you are initiating a trade. You have no profits to protect. So you start small and wait for confirmation that you are correct. Then you start looking for your next entry — at what level, and under what market conditions, will you increase your position size?

You’ll add to your position at the next logical buy point. If the stock has been advancing, you’re making money on your initial trade. Now, you watch for a resting phase. The stock falters a bit, but doesn’t reverse. Rather, it trades sideways and establishes a new support level, below which the stock is unlikely to fall. It now starts moving higher and looks like it’s going to test the prior, pre-rest high. Boom! You increase your position size, and place a stop just under the new, established support. This stop covers only the new purchase, not the entire position. Your original stop remains where it is. You don’t move it up. You’ve got a profit on that position, and that gives you a profit cushion. If the stock now moves against you, your most recent stop might be hit and you lose money on that new position…but the existing profit from your initial position protects you from losing money on the stock. You’ve cut your risk and are still profitable, despite the fact that the stock did not continue higher. So the trade that you had hoped for did not materialize. You were hoping for big gains, but instead have made just a small amount of money.

You weren’t “right” about the stock because it did not allow you to build a full position. But you weren’t wrong either. Your plan actually worked out pretty well. Your worst-case scenario played out, but you did not lose money on the trade.

Look, that’s trading. You’re going to take small losses on some trades. You’re going to make only small profits on other trades. It’s not because you are a chiseler. It’s because you will never have a 100% track record. Some of your trades will work, and some will not. But if you contain your losses on the ones that do not work, then the profits that you make on the ones that do work will more than compensate for your losses. Overall, you’ll be profitable.

And being profitable is your first step in your trading career. Once you gain the skill and discipline to trade this way, your next step is to tighten up your criteria for trading decisions. Establish additional rules that allow for the highest probability trades possible, and thus increase your number of profitable trades.

But that’s for another day. 😎

See you in the forum.

–Dan

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