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.
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