This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com
I’m beginning to see stop losses and R multiples in a different light lately, and especially since my last trade. I wanted to write about what a stop loss is and what it isn’t.
What A Stop Isn’t
Many people see their stop loss as the point that they admit that they were “wrong” about taking a position. “If it goes against you to the point of hitting your stop, then you were wrong about the trade” is the typical mentality. Your initial stop should not be the point at which you admit you were wrong about a position. That’s not what it’s for! Unless the trade spikes down to the stop instantaneously, then you were wrong about the trade long before that. For example, I was wrong about my PALM trade pretty much as soon as I entered. I stayed wrong for a couple of hours, and finally capitulated at my stop. Do you see the difference? It wasn’t the stop that proved me wrong, it was the price action immediately after my entry that clearly said that my position was wrong. By the time price got to my stop, my position had been cold and dead for a while. PALM may take off later, but my position was wrong at the time I took it. Waiting for a losing position to hit a stop to be declared wrong is like calling back a mugger who just ran off with your wallet to tell him he missed some extra cash in your pocket.
Think of it this way: Say you’re a mountain climber, and you like to scale cliffs to see the beautiful scenes at the top. But there’s a big downside–straight down! So what do you do? You use a safety line. You pick a place to put a bolt into the rock, and you tie off your line there. That is your stop loss. Why do you do this? It’s there to catch you should you happen to slip and be unable to recover. Do you wait until your safety line catches you to realize that you have begun to fall off the mountain? No! If you always did that, one of those times it may fail and you’ll take the big plunge. If you begin to slip, you catch yourself and reposition. In climbing, you might grab another outcropping or dig into the surface with your tools. In trading, that means you get out when you find that you’re going the wrong way.
So What Is A Stop Then, Wiseguy?
A stop loss serves two functions: To cap your maximum downside and help to size your position. When you choose a maximum amount you want to risk on a trade, that is capping your maximum downside. You shouldn’t think of it as your ante, or your pay-to-play. You want to lose $0 on every trade! Of course that’s not possible, but you should strive for it. When you pick an R value, that should be your worst-case-scenario loss: a managed loss that lets you keep trading long term should the worst come to pass. After picking that R size, you pair that with your actual stop price level to size your position to maintain your capped maximum downside. Usually, it makes sense to choose a stop based on the chart, support/resistance, candle highs/lows, etc. However, don’t just blindly approach the stop as the point at which the trade is proven wrong! The stop level may invalidate the setup if it is hit, but the trade may be above the stop and still not be proven correct as with my PALM trade.
So How Do I Know When My Position Is Wrong?
This is the easy part–your position is always wrong! Until proven correct, that is. If you enter and price moves in your favor, it is correct for the time being, and you have the luxury of waiting around to see if it bears fruit. But if you enter and you go underwater, have a plan to determine for yourself when to throw in the towel. And your stop loss point should not be that plan! On my PALM trade, I should have removed my position when the breakout did not occur for 2-3 candles after my entry, and I was still below my entry point.
Hopefully these thoughts will help all of us to lose smaller and faster, which is the only chance a trader has to survive the losing game of trading.
EDIT: Per Richard’s comment (#5), I think that some clarification is in order. I think that your timeframe has to come in to play in all of this. The trade management should always be done based on completed candles in your timeframe, with the only exception being your stop, which is your worst case loss at any time. When I say price moves in your favor, I am imagining that the action according to your timeframe completely clears your entry, like this:
That doesn’t mean that you are correct or not based on profitability tick by tick (unless that is your timeframe!). If the trade stalls, even after being proven correct, you have to determine if you should take the profit or stay. Every trade has a beginning and an end, even the “proven correct” ones. My point is, you have no business waiting around for a clear loss (the inverse of the picture above) to turn into a profit.
I actually think you don’t quite have the right idea… but I don’t have time to write an alternat article right now. I’ll just say that I think it’s really never about whether you are showing a profit or a loss, but rather if the price action is in line with your expectations (as in, the scenario you imagined in your head about the price going forward).
I don’t think people should look for any excuse to exit a trade, just because the price is below their long entry. After all, they hopefully picked a stop that would be below the leeway they are willing to give the stock within their setup. So generally, I think they would have to see something that confuses them, or a negative market turn, to change their minds. (like for instance, you posted on twitter that you couldn’t figure out whether they were buying or selling PALM at 19… that’s a good clue that you don’t need to be in the stock anymore.. you have no idea what’s going on with it)
By the same token, when you have a profit, that’s not a license to wait around to see if a trade bears fruit. Rule #1 (reduce and remove) should be applied in those situations, too.
To me, that’s what the example in the phantom book was all about… they say (1) here’s what I expect the stock to do over the course of the day, and then (2) I use Rule 1 when it does something I didn’t expect.
This is a subject I’ve been giving a lot of thought to lately. I used to move my stop fairly quickly. In fact, I was probably staring at Level II and getting nervous.
As I reviewed my trades in StockTickr, I’ve realized that I was moving my stop way too soon. Sure, there were trades where I’d save 0.5R or maybe a little more by doing it, but I missed out on over 10R worth of profit by moving my stop too soon.
It’s something I’m still playing with.
Richard, I dont think he was implying that people should exit a trade as soon as it isn’t going their way. Just that a stop is not the only indicator that a trade is going away from you. For patterns such as PALM, there was a time element as well. Prospectus may have tolerated a much higher down tick immediately after his entry, but then expected it to bounce. Instead the sideways motion indicated a break in the pattern, showing that the stock’s motion is no longer expected to go in any direction, and when you dont have an expectation, that is a great time to get out!
I expected my PALM trade to breakout, and it didn’t. That’s when I should have exited instead of waiting for it to get stopped out. It wasn’t just due to it being in the red.
When are your expectations to not make a profit? ;-) I’m not advocating that absolutely any move below your entry should get you out. Just that you shouldn’t sit on a position just because it hasn’t hit your stop yet.
You shouldn’t look for any old excuse to exit a trade, but you shouldn’t hold on to one without confirmation of it being correct, either.
The Phantom book was also written for a longer timeframe than daytrading. It’s a bit of a different animal since we’re quick to make our moves. Lots of “investors” buy and hold on to a losing position for months at a time, which is clearly violating rule#1.
I am mainly taking issue with the paragraph under the last heading. It says your trade is correct for the time being if the price has moved in your favor. I disagree with that. It says showing a profit gives you the luxury to hold onto a stalled trade. I disagree with that. And, it seems to imply that a trade can never be correct unless you are currently showing a profit. I disagree with that, too. If I felt that way, my stop loss would always be 1 cent under my entry.
Hopefully not to be too pedantic, but when you’re climbing, the rope is there to save your life, not to cut your losses. When you fall, you drop until something catches you. The only time I’ve ever caught myself or seen someone catch themselves was when the “drop” was really just a foot slip. From that point, you go down until something catches you and hopefully it’s a rope and not the ground.
Contrast this with stocks where normal behaviour is for a certain amount of up-down gyration. When stocks go down, they don’t go down to 0, and they don’t take 3 seconds to go there. When stocks drop you can sell any time this day, week or month, it just potentially gets more painful. With climbing, if you try to catch yourself you will break bones, dislocate shoulders, or rip off fingers.
When you feel a fall coming in climbing, you push yourself off from the wall so that you drop cleanly. When you feel a fall coming in your stock, you might lighten shares or tighten your stop but you still stay active.
It would be nice if trading was like climbing so that, at the first move down you would bail. It would be clean and simple. Stocks don’t move that way, and they have a lot of noise in their movement, little eddies against the larger current. When you place a trade, you’re picking a direction and a timeframe, and hopefully setting a stop so that you give yourself the opportunity to travel with the current but not bail when the first eddy joggles you around. (Hey, trading as kayaking – there’s a new metaphor! :) )
I’m thinking that you might be looking for multiple exit strategies. The first would be a volatility-based exit (bottom of a previous candle in the Dummy method) and the second might be a time-based exit where you start moving your stoploss up or peeling off shares every 15 minutes that the trade hasn’t moved in your favour. You might also exit the trade entirely if, after 60 minutes, the trade hasn’t moved at least 1R from your entry. (Note that I don’t take Dummy trades so have no idea if these would work, just things you might want to check out.)
As Richard says, stalled trades are problems, regardless of whether they’re profitable or not.
Great article. I like your comment on candles. The CLOSE of the candle, in your given timeframe, is most important. Caveat that perhaps that if a trade goes R 1.5 or thereabouts in your favour, it shouldn’t retrace much below the top of your entry candle. If it retraces much below that, I usually bail.
What Richard and Tyro said about stalled trades just hit me between the eyes!
What’s the whole strategy behind dummy trades? A high-volatility move followed by a low-volatility consolidation, then if it breaks in the direction of the first move you enter to ride the new expanding volatility move. Entering before the consolidation breaks is dumb, since it could really break either way.
When I sat in my PALM trade, it was the same as if I front-ran a dummy trade! A consolidation can break either way, so if your trade stalls, it’s very risky to stay and wait for the break. I think that’s what you were trying to get through to me, Richard.
Jesse Livermore used to probe the market by sending in huge market orders and watching how the tape reacted. If he sold a big block of shares and the price didn’t give way, he knew there was buying support there. I was trying to read the same kind of thing from PALM’s time and sales, but I only see the transaction. I don’t know if it was from a big seller or buyer. Livermore knew because it was him doing it!
I guess the moral of the story is beware a stalled trade, unless you have more information. Thanks, Richard and Tyro!
Livermore’s tests. Look to see if the trades are going off at the bid or ask. That’ll tell ya. Do big trades at the bid make the stock go down? Ya don’t need to know who’s doin it.
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