Managing Risk and Protecting Profits

Thomas Aspray Professional Trader & Analyst,

Whether in competitive sports or piano playing, it pays to practice, practice, practice, which is also true in the art of stop placement. Here, technician Tom Aspray reviews a few trades from years past to help improve your current stop management skills today.

In a previous trading lesson, Mastering the Basics of Stop Placement, I shared some examples of how I place initial stops and how they are adjusted as the trade progresses. Using past recommendations as examples, I hoped that the reader would gain some insight so that they could improve their stop management as well as learn how to better protect their profits.

From the response I received, it appears that I was successful and the process also allowed me the opportunity to dissect many of my past trades, which is always a good learning experience. Through additional examples from years prior, I would also like to offer some suggestions on what might have been done differently.

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2012 was a good year for the healthcare stocks as the Select Sector SPDR Health Care (XLV) was up 15% by the end of November of that year, while some of its industry groups like biotechnology did much better. It was one of the industry groups that I focused on in May of that year as I recommended going 50% long Amgen Inc. (AMGN) at $68.54 and 50% long at $67.12 with a stop at $64.76 (risk of approx. 4.5%).

AMGN had broken out of a four-month trading range in April of that year and was consolidating in May. The initial stop, line a, was placed well under the April lows. In early June, AMGN had a low of $67.21 and hit the first buy level. Two weeks later it overcame the resistance at line b and completed its continuation pattern. The stop was then raised (point 1) to $66.89, which reduced the risk on the position.

AMGN made a high in late June of $73.75 and after a brief pullback turned higher again. This created a short-term swing low and on June 29 (point 2) I raised the stop to $69.34, which was well under the low at $70.88.

After a brief correction from the new high on July 3 at $75.17, AMGN again moved higher, so on July 9 (point 3) I recommended selling ½ at the position at $76.88 and tightened the stop to $73.46. This was just under the low of $73.61 on July 5, and in hindsight, was probably too tight as under $72 would have been better. I was fortunate to avoid being stopped out.

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The sell order was filled six days later (point 4) and AMGN hit a high a few days later at $80.25. Just three days later AMGN was back to $75.70, but soon after rallied sharply to another new high of $84.39. Therefore, on August 9 (point 6), I raised the stop to $74.68 as I did not want to see a drop below the prior low of $75.70.

NEXT PAGE: Win Some, Lose Some

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As the chart indicates, AMGN lost some of its upside momentum as the month progressed and on August 30 (point 6) the stop was raised further to $79.76. AMGN started to look more toppy in early September as after retesting the prior high at $85.27, it corrected back to $80.60.

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Several days after the low (September 20) I became much more defensive as the weekly relative performance or RS analysis had formed a negative divergence and the daily OBV was below its WMA (point 7). Therefore I recommended tightening the stop to $81.44 on a move above $82.80 and advised selling the remaining position at $84.33. This would have been filled a couple of days later at point 8.

As the chart shows, AMGN eventually had a high of $89.95 but then dropped back to $83.68, which was below the prior swing low of $83.98. If I had stuck with the position and just kept moving the stop there was a good chance that I would have been stopped out at a level below $84.33.

Another healthcare stock that I liked in the spring of 2012 was Pfizer, Inc. (PFE). My bullishness on PFE was based on bullish signals from the monthly analysis and because it was yielding close to 4%. On April 2 I recommended going 50% long Pfizer, Inc. (PFE) at $22.22 and 50% long at $21.64 with a stop at $20.44 (risk of approx. 6.8%).

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The stop was under the year’s low from late February at $20.75. On April 14, PFE dropped to a low of $21.77 but then rallied sharply above the prior high, so on April 26 (point 3) the stop was raised to $21.28.

On the sharp sell-off in early June, the April low was violated as PFE eventually had a low of $21.40. Since the weekly OBV had confirmed the previous high—and because of the attractive yield—I stuck with the position.

When you are buying a stock primarily for its yield, I suggest that if it rallies 5% or more above your entry level that you use a stop close to break even. The drop to $21.40 put the position down about 3.6% from my entry level, which was more than I like normally like to give back.

Fortunately PFE surpassed the April high in the middle of July and on July 19 (point 5) I raised the stop to $21.86. This was just under the mid-June low of $22.05 and the July low of $22.00. Just over a month later I was able to raise the stop to $22.88, which was above the entry level and also below the late July low of $23.07.

PFE had a nice rally in late September and early October as it peaked on October 18 at $26.09. The following day (point 7) the stop was tightened further to $24.54, which was just under the late September low of $24.70. The stop was hit on November 1, point 8.

Though the approximate return on the trade—including dividends—was just over 12.4%, I regret not taking partial profits in mid-October of that year when prices were close the weekly starc+ band.

NEXT PAGE: Should Have Used a Tighter Stop

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Apple Inc. (AAPL) is a stock I follow pretty regularly and as the stock market was bottoming in early June of 2012, I noted that AAPL had made its low in the middle of May, which was consistent with a market leading stock.

Even though the daily OBV was not impressive on June 11 of that year, I recommended Apple, Inc. (AAPL) along with other big technology stocks. With AAPL closing at $580 I recommended going 50% long Apple, Inc. (AAPL) at $566.80 and 50% long at $559.60 with a stop at $545.65 (risk of approx. 3.1%). The stop (red line) was placed just under the early June 2012 low of $548.50.

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On June 28 (point 2), AAPL dropped to a low of $565.61 before a seven-day rally to a high of $619.87 (point 3). The stop was then raised to $564.80, which was just under the prior low. The sharp drop in the latter part of July took AAPL to a low of $570 (point 4) and tested the 50% Fibonacci retracement support of the rally from the May low to the July high.

When AAPL made a new rally high of $621.73 in early August I raised the stop to $575.64 (point 5) to lock in a small profit. While I was on vacation in August of that year, AAPL made new all-time highs at $674.88, so upon my return I raised the stop slightly to $584.20, which was well under the psychological support at $600.

By the middle of September, AAPL made another new high at $685.50 (point 7), so I raised the stop quite a bit to $633.79, which was well under the late August low of $648.11. Of course, AAPL quickly pushed above the $700 level, hitting a high of $705.07, which was not far below my August 2012 upside target at $714.

APPL gapped lower on September 24 and heavy selling the following day (point 8) was a sign of weakness. Either closing out the position or using a tighter stop would have been a better approach than keeping the stop at $633.79, which was hit almost two weeks later, point 9.

In the retail space Macy’s, Inc. (M) has always been one of my favorite stocks, especially during the fall, which is a strong seasonal period for this industry group. In July of 2012, there were some positive technical signs for the retail stocks like Macy’s, Inc. (M).

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The weekly chart showed that the 50% Fibonacci retracement support from the August 2011 low had been tested with the 61.8% support at $30.04. This was a classic example of how Fibonacci analysis can help you determine good entry levels when no one else is looking.

There was also good chart support from the July 2011 highs at $30.40-$30.65. At the time, the relative performance or RS analysis had turned up from support after confirming the previous highs. The OBV was below its WMA but was holding well above support, line d.

NEXT PAGE: Protecting Profits During Earnings Season

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On July 11, 2012 the recommendation was to go 50% long Macy’s, Inc. (M) at $32.44 and 50% long at $31.46, with a stop at $29.58 (risk of approx. 7.4%). Since Macy’s was still declining I felt as though a wider stop was needed so it was placed under $30 and the 61.8% support. This was a higher risk than I normally like to take on any one position.

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The low was made the following day at $32.31 (point 1) and just six days later the stock had moved above the prior high suggesting a short-term low was in place. After a pullback on July 24 (point 2), the stop was raised the following day to $32.18, which was about 0.5% under the previous low. On August 7 (point 3), just before Macy’s reported earnings—and with prices apparently stalled below the 61.8% retracement resistance—I recommended selling half the position.

As I noted in an my article Fibonacci entries and exits “I felt comfortable taking a quick 14.6% profit, as the overall market was not looking that strong and an earnings downdraft can never be ruled out. If the technical readings for the overall market had been stronger I would have been more likely to hold on to the entire long position.”

Half of the position was closed out at $37.20 and the earnings were strong as the stock rallied to a high of $40.80 on August 30. Prices reversed from the highs and on September 13 ( point 4), I raised the stop on the remaining position to $38.26, which was hit three days later, point 5. Macy’s, Inc. (M) eventually had a correction low of $36.94 on September 28 of said previous year.

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In early November of 2012 I recommended three oil stocks and one ETF in Pumped Up Oil Stocks. One of the stocks was Valero Energy Corp. (VLO) as I recommended going 50% long at $29.68 and 50% long at $29.14 with a stop at $27.68 (risk of approx. 5.8%). VLO had closed the day before at $30.06

VLO had been trading just above and just below the 38.2% support level with the lowest low at $27.89 and the 50% retracement support at $27.19. The relative performance had turned positive and the chart showed an apparent flag formation or a continuation pattern, which is one of my favorite setups.

Even though I was looking for pullback, I felt that the risk was too high using a stop under the 50% support. A stop at $26.92 would have increased the approximate risk to 8.4% from 5.8%. Both buy levels were hit over the next two days as VLO had a low of $28.56 on November 15 as the stock market was making its low.

I was looking for a convincing move above the four-week high at $30.57 to indicate that the correction was over. This occurred when the downtrend, line a, was overcome on November 23. The stop was next raised to $28.38, which was just below the November 15 low.

NEXT PAGE: Most Common Stop Placement Mistake

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I also recommended going 50% long Hess Corp. (HES) at $54.42 and 50% long at $53.66 with a stop at $51.28 (risk of approx. 5.1%) three years ago. HES had closed at $55.62, which was just above its downtrend, line d. The stop (line 6) was placed under the late October low of $51.60 as well as the late September low of $51.87. The 38.2% Fibonacci support was at $50.60 but the risk was too high using a stop under this level.

HES reversed sharply the following day (line 5) and hit both buy levels as the low was $52.82. Two days after it was recommended, the stop was hit and five days later HES had a low of $48.20. At this price the loss would have been doubled from 5.1% to 10.8%. Clearly using a stop under the 38.2% support would also not have helped as the 50% support at $48.51 was eventually also broken.

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In the article I also recommended the Select Sector SPDR Energy (XLE), which was stopped out for an approximate loss of 3%.

The most common mistake many make is to use a stop just under what appears to be an important low instead of looking further back in time for a low fewer are watching. The action in the Semiconductor HOLDERS (SMH) in 2012 provides a good example of past performance, even though past performance is not indicative of future results. However, it is still important to note that SMH made a low of $30.34 (point 3) on October 23, 2012. SMH then rallied sharply and came close to the resistance at $32.50. Those who were looking to buy SMH on a pullback may have used a stop 0.5% under the October low at $30.19 or 1% under it which would have been at $30.03.

SMH started to drop sharply on November 14 and on November 16 dropped in early trading to a low of $30.00 (point 4). The candle chart shows a hammer formation that day (point 4) as SMH closed near the day’s highs at $30.51. I am sure that there were quite a few who were stopped out on this intra-day sell-off.

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A better alternative would have been to look at the June 4 low of $29.57 (point 1) and the July 17 low of $29.56 (point 2). This support by November was much more important and if it was violated it would have been more significant. When making a recommendation I do try to determine where the majority may place their stops and then look for a different level.

These examples, despite being from a few years prior, I hope, will still further illustrate that stop placement is more of an art than a science and that it is a skill that is acquired over time. They also illustrate that while my stop placement worked well in some of the cases, there was plenty of room for improvement even after 30+ years in the markets.