Setting protective stops is as much of an art and it is a science. The good news is that with a little common sense and experience, you’ll have a pretty good feel for where they should go, writes Dave Landry.

Before we get into that, how about an amusing anecdote?

Way back when the earth was still cooling and I was focusing my energies on beer drinking and “dear” hunting, oops, I mean working on my undergraduate degree in computer science at USL, I remember an entertaining tire pitchman.

His name was Sam Behr. Sam became a local celebrity by his tell it like it is tire selling: “Tires ain’t pretty, they don’t smell good…but you gotta have ‘em!” He also got into a little hot water by saying God told him that he’d die if he didn’t sell 80,000 tires next month (borrowing an Oral Roberts line).

What does this have to do with trading?

Well, money management isn’t pretty, it “ain’t sexy” but you “gotta have it.”

Every trade, no matter how well-thought, has the potential to turn into a losing trade. That’s a fact. That goes for you, me, and that guy who screams on TV. Therefore, stops must be used.

So, how do you set protective stops?

There are only three questions that you need to ask yourself when determining where the stop should be placed:

1. How long do you intend on staying with the trade?
2. How volatile is the stock (or other underlying instrument)?
3. Where would you be wrong as a trend follower?

The longer you intend on staying with a position, the wider your stop will have to be to ride out the market’s gyrations.

So, you want to ride a long-term trend and make a lot of money? Well, you’re going to need a super wide stop. Unfortunately, the stops need to be so wide that trading only for longer-term gains simply isn’t feasible. Further, your accuracy is also going to be low because great trends don’t come along every day.

The combination of those two is a recipe for disaster. We’ve all read about these famous traders who amass a fortune trend following. What’s missing is the Paul Harvey “rest of the story:” many have subsequently blown up.

This is why I use a hybrid approach to money and position management. I go in for a “more sure” swing trade with a somewhat tighter short-term stop but then begin gradually allowing the stop to widen as the position moves in my favor. This way, hopefully, I’m able to stay with the position for a long, long, time. This allows me to “have my cake and eat it too”—to trade for both short-term and longer-term gains (see videos for a lot more on this). 

As far as #2, there are some serious statistical measurements here. And, since markets aren’t normally distributed, you have to tread lightly with them.

I do like to use historical volatility (HV) to give me a feel for things. See this column for a definition and the math but don’t let that scare you. You don’t have to know very much about electricity to flip a switch and get light. Just know that HV is how much the stock has bounced around in the past, hence the word “historical.”

Also know that it makes a great measurement of so called “beta”—how volatile a stock is on a relative basis. And, BTW,  you can't beat a market with stocks that are less volatile than the market. 

The bottom line is that common sense is your best ally when setting stops. If the stock bounces around 4-5 points a day, then setting a stop within that range all but guarantees you a loss. As I often preach, there’s a popular method that says that you should use an 8% stop on all trades.

I pointed out that some of the positions began with stops in excess of 30%. 30%? Come on Big Dave, “I’m not going to use a stop that wide!” If the setup calls for a wide initial protective stop, then that’s what you have to use.

You compensate by adjusting your share size to keep the risks in line. In fact, I firmly believe that trading more volatile stocks (within reason) is actually less risky that trading less volatile stocks. See Understanding A Stock’s Volatility-Better The Devil You Know.

May the trend be with you!

Dave

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