How to Set Protective Stops
08/11/2009 12:01 am EST
A protective stop loss is the point at which you have pre-determined a maximum allowable loss based on your risk parameters for a trade or investment. Not taking stops is one of the biggest demons wreaking financial havoc on most trading accounts, and even worse is how it affects your personal trading psychology. Stops should be your friend—not your enemy—as they save your capital from potential disaster. In this commentary, I am going to discuss where to set stops, not the psychology behind them.
It shocks me that many traders ask for a suggested stop in a trade they entered. First, stops must be determined before entering the trade. How else could you determine the risk/reward of the trade if you do not know this ahead of time? Stops are set below demand. These are based on technical analysis, not arbitrary dollar stops. The maximum dollar stop determines share size after determining suitability of a trade and the risk/reward.
Don’t be set on a target. Targets are merely focal points to help us determine if the trade warrants our capital. Once you have entered the trade, you are in “trade management mode," adjusting stops as the stock and market internals unfold. One should continually revaluate the information as it happens. Do not unwisely give your profits back to the market. If you are in a swing or core trade, you might simply trail stops under prior major pivots (e.g., under an hourly pivot if an active swing trader).
Some circumstances in which I will sell early and not let the stop take me out of the trade include:
- If the stock has run in a climactic manner and I want to sell into momentum strength because a retracement is highly likely. I will sell on a reversal bar on a smaller time frame, or…
- If the market internals are falling apart and the likelihood of my stop being hit is high, even if a trailing stop.
I also encourage traders to move stops to break even when reasonably profitable and in a technically correct location based on the price charts. In other words, you can't simply be in the money an arbitrary amount and then say, "Okay, break even stop now.” One rule I use in moving stops to break even is to ask myself, "Would I want to still be in this position if it retraced at this point to stop me out?" Because of the positive psychological mindset created when booking partial gains, we also advocate selling incrementally into strength when appropriately profitable. Obviously, use common sense per the chart pattern, as a $.25 gain in a low-priced stock might be the equivalent of a $1.00 gain in a higher-priced one.
Finally, I advocate time stops. If the stock is not doing what you expect in the time frame expected, either get out or reduce exposure. Trading is a business, and stock is our inventory. If the inventory— which is tying up capital—is underperforming, close it out and put it to better use. Constantly reevaluating will help keep you in good trades longer and will get you out of bad trades faster.
I have always adhered to a policy of selling at least part of my positions into strength and when I can; not when I have to. Be objective in choosing the best trades with the highest risk/reward ratios, and then manage appropriately and you will find a good balance in your trading and/or investing.
By Ron Wagner