Friday, December 03, 2010

Stop Orders for Stock Trading

I have long considered an exit strategy to be one of the paramount necessities in successful trading. When I write that, I don't mean an exit strategy that comes as some afterthought once a trade has already been entered. I mean one that is considered, developed, and in place at the time the trade is entered. All too many retail traders seem to fail to consider specifically and precisely what circumstance or circumstances will trigger them to pull the plug on a trade and as a result, tend to let their losses run. Of course, the idea is to let profits run while cutting losses.

I am well aware of the arguments that some advance for refraining from placing a stop, but if one is not able to watch the market quite closely (i.e. they have some other job that distracts them from their trades) then placing a stop loss order seems to me to be a prudent action. Better to take the quick loss with a stop than take the larger loss by convincing oneself that "it'll come back." In fact, the "it'll come back crowd," in my experience are among those most likely to be out of the trading business most quickly.

Even those who are able to watch their positions quickly may consider placing a stop loss or trailing stop loss order to avoid following the advice of that little internal voice that may be saying: "Oh, I'll let it go another dime." All too often it seems that dime becomes a quarter or a dollar or more.

For me the difficult issue is not whether or not to place a stop, but where it should be placed. The idea is to allow the position to have some breathing room but at the same time to set up the trade so that losses are promptly cut when they arise. A stop loss order can do that but since where to set it is a very subjective judgment it takes time and practice to become relatively good at doing it. My advice is that it is worth the time and practice (as in paper trading) to become as good as one can at setting stops. That does not mean that a trader won't ever get whipsawed out, it just means that he won't suffer the whipsaw as often and he will succeed in cutting losses. When we are stopped out, it is not a bad idea to keep watching the stock for a while to see if it does reverse in which event a re-entry may be in order. Re-entering is something few retail traders do, but it can lead to some fine successes.

In my experience teaching and coaching traders, I have found that many have a tendency to be impatient. While I do not advocate impatience when seeking an entry, I might suggest that once a position has been entered a time stop might be appropriate. Over the years, I have spoken to some successful traders who close a trade if it has not become profitable in 3 days, or in a week. They set their own time tolerance and if they don't get a move in the direction they seek within their pre-set time frame, they just close the trade. Naturally that can result in missing some moves that might occur shortly after their exit, but that is something they understand and accept. That approach might also add to the number of commissions they might pay in a year but at least it helps deal with their internal difficulties with patience.

Bottom line as I see it is that cutting losses can be critically important to good trading. Setting stops is one way to accomplish it. If you have others that work well, that's fine, but traders should have some exit strategy and a way to implement that strategy.

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

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Jim G. said...

Stop Limit orders have no place when dealing with penny stocks. Other than that you are right on point. Case in point is SAEI on Friday. A disaster for anyone who had a Stop Loss in place.

Bill Kraft, said...

Thanks, Jim G. You are absolutely right. Penny stocks are a different animal in that they can be extremely volatile and are very, very, very speculative. Most are cheap for a reason and though money can be made on a penny stock, not too many retail traders ever succeed trading them. Stops are exceedingly difficult if available because of the wide percentage swings they can take.
Bill Kraft

Anonymous said...

As one of your coaching students, Bill, you have helped me to understand the importance of this matter and to give it serious thought.

I'm still developing my exit plan BUT for now, I think that one plan that works for me is to stay in a position when it remains above a pre-determined moving average. (Note: I'm buying in-the-money calls many months out.)

I recently closed out a position at about a 35%+ profit that had, at one time, been over 60% profitable. At the time, my exit point was a cross below the 50-day MA. I am now considering a different strategy: reducing the moving day average to something like 20 or 30 days as the position becomes more profitable. I'll be out sooner with, hopefully, a greater profit. I recognize that I might be out sooner -- and the position could climb to greater profitability without me. No plan is perfect including this one.

There is still the challenge of getting out when you've said you will. I finally closed two positions that had penetrated the 50-day MA early this week -- and didn't do it promptly. I waited for two days hoping the underlying stock would rise. It didn't and I took a greater loss than I should have.

I am trying very hard to keep in mind that SMALL losses are good. Keep losses small, no matter what.

It's not easy -- but it's getting easier (she writes, gritting her teeth!)

~ Nona

Anonymous said...

The problem I have is not exiting the entire position once I've decided it's no good. I keep thinking "Maybe I should keep 100 shares, just in case." So I'll sell 90% of my position but keep that remaining 10% for infinity.

I eventually reach a point where I can scroll through my portfolio without even seeing the smoldering remains of a bad investment. When I look at it and can't even remember why I bought it, I've reached the point where I can let those last few shares go.

Grant Johnston, Chico, CA

Anonymous said...

Here's something that might help, Grant: Keep in mind the paradox that by taking small losses you make bigger gains overall.

I've started chanting a mantra, sometimes out loud but always in my brain, that helps me keep that paradox in mind: "Small losses are good losses! Small losses are good losses!"

Hope this helps.

~ Nona

Bill Kraft, said...

Interesting approach, Grant. I'm curious how those 100 shares you hang onto "just in case" have fared over time. Thanks for an interesting and good natured note.
Bill Kraft

Bill Kraft, said...

Thanks for the great contribution, Nona. It definitely can be difficult to cut losses quickly even once a price has passed our pre-determined exit point since that 'little voice' inside us often encourages us to hang on because "it'll come back." One thing to consider might be to start with a moving average as you did with the 50 day as your initial exit and when you get a steeper move in your favor switch to a shorter moving average.
Bill Kraft

Unknown said...

The only loss that I put is Stop Limit. Trailing Stop I would put when my meat is cooked and any extra sauce is welcome. Stop Loss it itself is dangerous especially in these days of High Speed Trading (HST). I think HST is highway robbery and must be banned. The simple way to cut the gangsters to size is to apply the same trading fee for cancellation over and above a legitimate percent - say, 20% of one's trade.

Currently there is no bar to a High Speed Trader from issuing bogus orders only to light up the other buy/sell orders and then kill the order in a lightening flash. This makes Stop Loss a sitting duck because Money Managers with vast sums, and an unfair advantage of a peek at the order book, can easily manipulate the prices to the disadvantage of the general public. More people will get whipsawed as a result of HST.

I am pretty certain Stop Loss orders aggravated the Flash Crash. Those that lost money could have saved the day if they had Stop Limit instead of Stop Loss/Trailing Stops.

However, the idea that an exit strategy should be in place before opening a trade is pure wisdom. Where to place a stop is impossible to say but I for one determine it based on the Daily Chart/Weekly Charts. Smaller time frames don't work for me.

Unknown said...

Commenting on a previous post about liquidating a portion of the holding - this I find hard to accept in my trading strategy. I always sell all when the decision is made. My reasoning is: I'm closing a position because I am not sure of further profits. Now if you still have "hope", it sounds as contradiction to me because half of your brain says close and the other half says do not. In such a case why close at all? Or for that matter, hold at all?

In such cases a lot of people advise taking half of it off the table. But my thinking is the any which way the trade goes, you are going to lose on 50% of your position.

If I could (I wish) have a super run whereby I can pull off the principal and then have a sizeable chunk of profits, close to original investment, I could afford to keep it on the table to test fate. Now I would be playing with house money.

The biggest lesson I've learnt is to cut your losses and cut it fast. Even if that means you are proved wrong later on. My reasons for this approach are: you live to fight another day and downdraft is three times speedier than an updraft.

The ideal stop loss point is the Holy Grail.

Thanks for an interesting discussion on such an important issue.

Anonymous said...

Bill, in reply to your question about how I did when I've exited most of a position but kept a small percent, I hate to admit but I've never seen what I was holding come back. A couple of times the price has bounced around near where I sold but I've never had one get up to my entry point. I think most of the time it has been an impluse buy that turned south within a day or two of the buy. Another time it was an RV manufacturer that I bought and sold several times. The last time I wasn't paying attention when the bottom fell out. In fact, I was in the Arizona desert in my RV. When I got home and noticed the share price was below $1, I dumped most of it. But I kept some, just in case. Then gas prices went through the roof. The return from the few hundred shares I had held would not have covered the sales commissions. I think that was in the Fall of 2004 or Jan. Feb. 2005. I was still with a full service broker then. I'm not anymore.

Grant W. Johnston, Chico, CA

Bill Kraft, said...

Thanks for writing SUJIT. Stop limit orders to sell (as opposed to stop limit orders to buy) can be quite dangerous and may even prevent the trader from getting out of the position when he should or wanted to exit. As an example, suppose a trader owns XYZ that is trading at $36 and has a stop limit in place with the stop at $35, limit $34.25. Further assume the stock gaps down at the open to $34. He would still be in the position even though his stop was hit when it gapped below $35. While the stop was hit, the limit of $34.25 would prevent the sale of the stock since no one is willing to pay $34.25 (the limit part of the order) when the price has already fallen below that level to $34.
Bill Kraft

Bill Kraft, said...

Thanks, Grant. I hope many read your experiences since I suspect it is a fairly common issue. I sincerely appreciate your forthrightness.
Bill Kraft