How to Use Protective Stops

10/28/2009 12:01 am EST


Ron Wagner

Principal Partner,

A protective stop loss is the point at which you have pre-determined that the probability of the trade working in the direction originally intended no longer exists, so you exit the trade. Not taking stops is one of the biggest demons wreaking financial havoc on your trading account (and emotional well being). 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 us that many traders ask us 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? For longs, targets equal supply. 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 the 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 unravel. 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:

(1) 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…

(2) If the market internals are falling apart, and the likelihood of my stop being hit is likely.

We also encourage traders to move stops to break even quickly but by using bar by bar analysis to appropriately place that new stop. In other words, you can't simply be in the money an arbitrary amount and then say, "Okay, break even stop now," if a normal retracement might stop you out. 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 part of your position when up a reasonable amount. Obviously, use common sense per the chart pattern, because what is reasonable for your style of trading is only something you can write into your plan.

Finally, I advocate time stops. If the stock is not doing what you expect, and 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 get you out of bad trades faster.

By Ron Wagner

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