Friday, April 23, 2010

Some Thoughts on Stops

Recently a subscriber wrote on the blog asking how to avoid getting whipsawed out on stops when there are traders out there who hunt for clusters of stops so they can attempt to profit by triggering the stop and then enjoying a run-up. Assuming there are such traders (as I do) that can be a difficult problem. Before we attack that somewhat sophisticated issue, however, let's examine what a stop loss order is and what it does for those who may not have a clear concept of stops.

A sell stop loss order is an order to the broker to sell shares of stock when a specific price is hit. For example, suppose we owned 1000 shares of XYZ at $25.67 a share and that we wanted to cut our losses if the stock price fell below a certain level. In this example, we'll say we want to be out of our position if the shares go below $24.75 so we place a stop loss at $24.75. That order tells our broker to sell our position "at the market" if the share price touches or goes below $24.75. It is important to understand that the order does not guarantee us that we will get $24.75 a share; it only guarantees that our position will be sold at the then current market price if the share price touches $24.75 or below. We could get more than $24.75 or less. Assume, in our example, that XYZ closed last night at $25 a share and we have our $24.75 stop in place, but this morning the stock opens at $23 a share. Since $23 a share is below our stop, the order to sell our shares is immediately sent to the floor as a market order and we may get $23 a share or a bit more or less, depending upon the price when it reaches our place in line. Though we have taken a bigger loss than we may have thought, we nevertheless are out of the position where the stock is falling. That is better than taking bigger and bigger losses.

A buy stop order is an order to the broker to buy shares of the stock once the stop price is hit. Again, with a buy stop, once the price is hit, the order goes to the floor as a buy at the market order so we could pay less or even much more than the price at which our stop is set. For that reason, I never set simple buy stop orders, but use the buy stop limit order. That adds another element to the order. Once the buy stop is hit, the order then goes as a limit order so that I will not pay any more (though I may pay less) than whatever limit I set.

With that basic understanding of stops, the question becomes where one is going to place the stop. For purposes of this article, I am going to discuss only the stop loss order ordinarily placed when one already owns the stock and wants to protect the downside. I believe that the decision of where to place stops is one of the most difficult tasks of the trader. It involves some art to achieve superior results. The difficulty arises from some subjectivity that is necessary in placing what I would consider to be good stops. I have often urged the necessity of discipline in trading and much of the discipline can be achieved by lines on charts like price support or resistance or trend support or a moving average. The problem with the use of these great tools with setting stops is that any savvy trader has a clear idea of where the great bulk of stops are placed and, in any event, stops are visible to the market. In our earlier example of XYZ, suppose there was a horizontal price support at $24.80. There is a good chance that most stops are around the $24.75 to $24.80 mark so the traders searching for clusters of stops (such as those about whom the subscriber is concerned) would have little difficulty identifying the price to which they want to drive the stock to set off the stops.

Under current rules there is little we can do about the visibility, but even if they weren't visible, it is often a no-brainer to guess where they are. The art for the trader placing the stop is to be just outside the range where most of the stops are placed. That approach adds somewhat to the risk because the stop will be lower than those of the crowd, but it will also avoid some of the frustrating whipsaws. My best advice is that setting good stops comes with experience. Practice paper trading stops to see how close the dips come to your stop and whether you are getting whipsawed out or whether the share price turns just above your stop. With some practice, you may find the price coming within pennies of your stop and then turning back up. Again, that part is the art and I suspect it only gets better with experience.

by Bill Kraft, Editor
Copyright 2010, Makin' Hay, Inc.
All Rights Reserved


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To comment on Bill's article click on the "comments" link below.

17 comments:

M said...

Hello Bill,

I'm up in Canada, and was watching technical expert Ron Meisels explaining stops on BNN. He states to put a stop always in an uneven figure. For example at $22.95 instead of $23 to ward off stop hunters. Have you ever heard of this? If you put the stop limit at $22.75 in the above example, we will be guaranteed $22.75 or higher when the stop gets hit at $22.95 right? Without the limit, we could end up with a price less than $22.75. Would you recommend putting stops on all your investments, even those with high yields, and etfs that aren't that volatile that are core holdings? Thanks Bill, regards, Martin.

Anonymous said...

Day Trading I have been successful by doubling or tribling the ATR (Average True Range)at the price I buy.I also compare this to where the present support and resistance levels are so that my stop ends up not being too far or too close to either.
Tony "D"

Anonymous said...

One defense against the stop loss poacher is to use invisible stop loss orders, AKA contingency orders. Not many brokers offer this service, OptionsXpress (OX) does but surely there are others.

The way OX's works is that you pick a strategic price level and enter your contingent order. When the market hits that price, your contingency is met and the broker releases the order to the market.

This won't defend against the sophisticated trader who is poaching obvious stop loss levels, but it will defend against a market maker who is working stop-loss orders to his advantage.

DEKE

UrbaneGorilla said...

Hiding your stop is easy if you use a program that triggers a sell based on a stand alone program (Like TD Ameritrade's StrategyDesk. You just need to not place stops with the crowd. I'm not comfortable with the ATR stop as suggested above. I've been reamed using 2X the ATR. I prefer to buy on a dip and use the prior low as a stop, keeping in mind any long tails that may have existed at these prior lows. No point picking $25 as your stop if the market movers consistently shake the tree to see what falls out. I can also say that buying during volatile periods (options expiration week, Fed meetings, days prior to and after earnings..etc) is a great way to get stopped out. Lastly, learning the rhythm of the market is important. Buying at the midday low rather than the afternoon ramp up keeps you closer to your stops.

bijouxmeyers@yahoo.com said...

Both ATR and stand alone approach will fail if the poachers can spook the market. Whether one has the stop visible or not, if other traders can get dinged and their stops taken out, it will trigger a snowball effect i.e., the prices will start tumblilng in a downward action. And as a result of this, your otherwise well concealed order will now have to step out of the hide because the actual market price has met your hidden targets! Now you too would be exposed and will be scammed.

SO, the only way this will work is:
(1) SEC bans High Speed Trading with half second advantage to the big players
(2) Outlaws flash trading
OR
(3) All the traders become aware of the situation (danger they are in with stops) and do what the previous posters have suggested.

UrbaneGorilla said...

Agree with bijouxmeyers .. Everyone needs to keep in mind that we are plankton in the sea and whales eat lots of plankton. 70% of trading is high frequency trading performed by 2% (I think) of the companies out there ... Lets not forget front running either. The odds are stacked against the trader.

Anonymous said...

Stops are not visibe to the market. They are usually held on the broker's server.

Anonymous said...

Why not protect against a possible downturn by putting in a collar?

Bill Kraft, MarketFN.com said...

Thanks for writing, Martin. Yes, the theory of placing stops at uneven figures has been around as long as I've been trading. My experience is that it is marginally helpful, but in and of itself it is not a complete solution.
Bill Kraft

Bill Kraft, MarketFN.com said...

Tony D, thanks for your contribution. While I am not a day trader and have not used your methodology, I can only congratulate you if the plan is working.
Bill Kraft

Bill Kraft, MarketFN.com said...

Thanks, Deke, that is a method I use myself fairly regularly. It still requires judgment of where to place the contingency, but at least the stops aren't actually visible.
Bill Kraft

Bill Kraft, MarketFN.com said...

Thanks for writing, Urbane Gorilla. I agree with most of what you have written, especially the statement that "You just need to not place stops with the crowd." That's a little like the old baseball hitter's philosophy when asked how to be a good hitter and he replied "just hit 'em where they ain't." That, in fact, is the real art of placing stops.
Bill Kraft

Bill Kraft, MarketFN.com said...

Thanks for writing, Bijou. I wonder about the likelihood of the SEC taking the actions you suggest.
Bill Kraft

Bill Kraft, MarketFN.com said...

I've been wrong before, Anonymous, but all the information I have says stops are visible to the market. Contingent orders are held on the servers. Thanks for your note.
Bill Kraft

Bill Kraft, MarketFN.com said...

Collars are a way to go, but unless the trader is trading the legs dynamically the return is usually pretty sparse. Buying puts alone also protect the downside when one owns stock. I often use collars myself, but I don't let them sit. Rather I trade in and out of the call leg (usually) so that I can achieve greater gains.
Bill Kraft

Anonymous said...

Bill,
Over the years I have had many instances of "Stop Raids, Running the Stops, Clearing the Books," or what ever they want to call it. I have had Clients threaten to sue me, the Broker/Dealer, the Company whose stock was traded, and the SEC. None of it ever worked out for anyone's benefit. I have yet to find any one method of setting Stops that work for everyone and all the time.
For my own account, I calculate a stop price down 8% from entry and then review the 40, 20 and 10 Day Moving Averages of the issue. I watch the chart (to see those support levels that may be a order cluster point) and set the stop as far below as my account can stand. Then, I DO NOT enter that order as an official order, on the books. I have the advantage of being in the market all day, every day. I set "Alerts" on my quote system to remind me of the Stop. The discipline comes in actually pushing the button if the Alert/Stop triggers. Emotion must be overcome and the order must be entered no matter how much emotion says "oh, wait, it will come back up" Those are the most devestating words in investing or trading. I cannot imagine how many millions of dollars have been lost due to those deceptive words. As far as the situtation where the trader is whipsawed, I would recommend that if one gets whipsawed, do your best to put the experience behind you. Do not dwell on something you have no control over. Move on to another stock. If the Stops have been run and cleaned out, the vultures may still be circling. It may be well to avoid any further involvement, at least for a while.
The Old Trader
dsb

Bill Kraft, MarketFN.com said...

To the Old Trader -- thanks for an absolutely great contribution! Though my method in terms of percentage differs a bit from yours, I also hold my own stop with an alert set. I really appreciated your wisdom and helpful detail to our readers.
Bill Kraft