Stop Loss - Q&A
I get more questions about stop losses than about any other subject. Clearly this strategy causes traders a lot of pain and confusion. Some of it stems from the schizoid nature of our modern markets. But most of it reflects an underlying weakness in trade management skills.
What takes place at the end of a trade usually reflects decisions made at the beginning. In other words, the best entries usually lead to the most profitable exits. This is the most urgent wisdom I can give when it comes to stop-loss placement.
We can spend hours deciding whether a stock is a good buy or a good sell, but this emphasis is often misplaced. Over time, carefully chosen exits are more important than great entries. You don't believe me? Just ask all those folks who bought tech stocks in the late 1990s.
I've compiled a question-and-answer session that addresses the most important elements of stop-loss strategy.
Q - Where do I place my stop loss when shorting a stock that gaps down?
A - The most obvious place is just above the price level where the gap would be filled. But that's a generic answer. It's more effective to place the stop loss on top of converging resistance, such as highs, Fibonacci retracements and moving averages. A bouncing stock will have a very hard time getting through those levels.
Q - I'm getting stopped out of both my longs and my shorts in this market. Are my stops too tight, or should I blame it in the choppy market?
A - There are many reasons why stops get hit too often. It's hard to tell without knowing the specifics of each placement. This is a tough market, and you often have only two choices. First, place a tight stop loss and trade the small swings to avoid all the choppy reversals. Second, back up a giant step and trade the broader trend you see in front of your nose. In other words, the market is only choppy if you're a daytrader or if you flip positions every few days.
The trends are more obvious if your holding period is weeks or longer. But longer holds have a disadvantage when it comes to stop placement. You have to take on greater risk with longer-term positions, because stocks will wiggle around a lot more before getting from point A to point B.
There's one more caution in regard to stop placement. Your stops have to match your trading strategy. For example, if you're looking for a 3-point swing, you have to stay out of the market until your risk (current price to stop price) is a point or less. This goes back to the importance of picking good entry points.
Q - My stops get hit all the time. What am I doing wrong?
A - Keep those stops away from the most obvious support or resistance levels, such as round numbers. There's a lot to gain by pushing price through these levels. It cleans out one side of the market and sets up a vacuum headed the other way. It's one reason I'll actually sell short into a breakout or go long into a breakdown. Keep in mind that many traders look for price stretching through a barrier as a signal to go the other way.
Q - Should I use a flat dollar or percentage stop loss?
A - I never use percentage or dollar stop losses, at least for the initial placement. The first stop loss is always based on the price pattern and where current action violates the trade setup. Of course, you need good trailing stops once a position moves in your favor, and flat dollar strategies have a useful purpose in protecting profits. But I would avoid percentage stop losses in all cases.
A move of 5%, 10% or 50% says nothing about the current market or trade setup. You could enter a position where a stock moves 11% every day on average. So your 10% stop is at risk every day because of market noise, rather than anything else. A percentage stop loss gives the illusion of controlling risk without giving you the realization of what risk is in the first place. Why is this important? Reward and risk are joined at the hip. If you don't have one right, the other won't be right either.
There is a definable risk based on the pattern and where you enter the trade. Each trade has a different risk profile, and your trade entry tells you how much it can wiggle but still get you to the goal. You need to include this standard deviation in your stop-loss planning, or you'll take maximum loss after maximum loss.