Prior to the financial crash of 2008 there was an ongoing debate between fundamental and technical analysts as to whether investors or traders should use stops. The severity of the decline convinced many that stops should be used, according to MoneyShow’s Tom Aspray.
I have always advocated placing a stop order at the same time as your buy or sell order. It allows one to roughly quantify the risk of any investment or trade. By analyzing the risk it often becomes clear that the risk is too high. One of the most common mistakes is to raise the stop instead of lowering the entry level. If you are going to adjust the parameters in order to lower the risk focus on changing the entry not the stop.
In addition to the process of determining the initial stop, it is important to also manage the trade once a position is established. This is an art more than a science as every price pattern has subtle differences. Though I follow a systematic approach, the rules are not cut and dried. Clearly when to sell is an important decision in terms of managing one’s portfolio and can be the key factor in determining whether you are profitable or not.
Those who follow my daily column have been able to follow both the placement of the initial stop as well as how the stops are managed once a position is established. Because of time and space constraints the specific details of the stop choices are generally not provided. The goal of this lesson is to provide those details, and in the process provide more insight so that you can improve your bottom line.
In this first chart I would like to look at a historical example so I can share some of the basic guidelines that I try to follow. This will be followed by actual examples of trades and stops I have recommended in the past year.
This chart of the Spyder Trust (SPY) covers the period from March 2003 through early August of 2003. On March 12, the SPY made a low of $79.38 but then closed near the day’s highs. The volume was strong that day and increased over the next few days as the on-balance-volume broke through resistance. Seven days later on March 21, there was clear evidence that SPY had bottomed as it had moved well above the highs of the past six weeks on strong volume.
My favored strategy is to buy on a setback after an uptrend has been established. So on March 21, a typical recommendation would have been to go 50% long at $86.06. This was just above the 38.2% Fibonacci retracement support at $85.84 and above the round number of $86.00. The second 50% buy level was at $85.28, which was midway between the 38.2% support and the 50% support at $84.60.
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