Stop the Madness
Stockscores.com Perspectives for the week ending February 18, 2007
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In this week's issue:
There is a lot of confusion in the trading world about the use of stop loss orders. Where to put them, when to use them and whether they are in fact destructive to trading are all questions that plague traders. Stop loss orders are a valuable tool to protect capital but it is important to know when they are appropriate and how to apply them.
A stop loss order is an order that is contingent upon price. They are often referred to as stop sell orders because they execute a sell order either at a limit price or market price when a price threshold has been hit. For example, if you own a stock that is trading at $10 and want to protect your capital in case the stock should fall quickly, you may set a stop sell order at $9. If the stock falls to $9 your shares will automatically be sold at the market price or at a price above a limit that you set, provided the stock does not also fall through the limit.
This brings up the first question that many people have about stop orders. Should a market or limit order be used? A market order will certainly sell the stock, but you can not know at what price. If the stock lacks buyers after your stop has been triggered then you may find that your order to sell the stock gets executed at a much lower price than your stop price.
A stop limit order will not have this problem as you establish the limit to how low your stop order will be executed. The problem with a limit order is that you may not have your sell order filled if the stock falls so quickly that it goes below the limit price before your sell order is executed.
As a general rule, use stop market orders when the stock you are trading is liquid enough that the spread between the bid and the ask is tight and the stock trades at least 500 times a day. If it is less than this, a stop limit order will work better but you will have less protection against a rapid share price decline if the limit order is not triggered. When using stop limit orders, I suggest setting the limit lower than the trigger price. For example, if the stop price is $9 set the limit at $8.90 or something like that so that you have a greater chance that the stock will trade above your limit price once the stop order to sell is triggered.
But where should the stop order be placed? Many people suggest using a percentage rule to ensure that the percentage of your capital is protected. Having a 10% loss limit is often discussed but I caution against taking this approach.
The reason is that every stock has a different amount of price volatility. A 10% move in Microsoft may take months while the same percentage change in a penny stock could happen in an hour. It makes no sense to use a percentage stop for this reason.
Stops should be set just beyond a point where the price action indicates a change in control from buyers to sellers. You want to exit a stock position when the buyers lose control because at that point, the stock is more likely to go lower. That is what you are working to protect yourself against.
When reading charts, look for areas of price support as that psychological barrier where buyers should defend their control of the stock. A change of market control is implied if the stock price falls below these areas of support.
However, never set your stop at round numbers. Larger market participants who are looking to build a larger position size may actually sell some stock to drive prices lower with the hope that they can trigger stop sell orders that they can buy up to increase their overall position size. If you put your stop just below chart pattern support and just below a round number, where orders will tend to congregate, you will reduce the chance of having your stops gunned by another trader.
I hear many people complain about the use of stops and how they were stopped out of a position only to watch the stock go right back up afterward. This brings to mind conspiracy theories on the practices of market makers who manipulate the stock to shake out those shares sold on a stop trigger. While some market participants do play games to take your money, there is a far more important way to combat this problem.
Play the right stocks.
If you are patient and selective with the stocks you buy in the first place, and have a high standard for the positions that you take, you will have a much lower chance that your stock position will ever be stopped out. Enter trades that have a high probability of working and then set your stop price at a point that represents a real barrier for the market, not just based upon your tolerance for loss. If you hold this higher standard in your use of stop sell orders, you will find them far more effective for your longer term trading prosperity.
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Information affects stock price. The more important the information, the greater the effect on price. Recognizing that there are market participants who act on information that has not yet been made public, we can often predict the arrival of significant news by monitoring market activity. Statistically significant abnormal activity is often an indication that positive new information is becoming a factor in the market. The Abnormal Activity Market Scan and Strategy seeks out the abnormal behavior that can telegraph the future.Back To Top
1. T.CPN
The share price of T.CPN jumped up 11% on Friday and trading volume higher than normal. There was no news that I could find to explain the price jump and yet the stock has broken through to highs never seen before. I hypothesize that some traders bought the stock aggressively on Friday because they know or believe that news of positive fundamental change is coming soon. If support at $0.81 is broken, then we can consider Friday's market action to be misleading.
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References
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Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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