Stops & How To Use Them

When I was first getting into trading, one of the books I read (and actually found by accident) was published in 1964 and entitled "Wall Street: The Other Las Vegas."  The book was written by Nicolas Darvas, who's original background was totally unrelated to trading.  He was a professional dancer and toured the world with his dance company.  He also became a millionaire stock trader at the same time.  Trading was a new and unanticipated sideline for him, but it eventually became his co-career.  His book is a great read, and if it is still in print somewhere, I recommend it.  Although it was written some 40 years ago, it still captures many of the key strategies employed by successful traders even today.  One of the most important is the "Stop Loss."  Mr. Darvas' use of the stop loss was so effective, it was actually banned by the NYSE briefly during the 1960s, until pressure from traders forced the Exchange to reinstate it.

There are variations on the stop.  One is the "stop-loss."  The other is referred to as the "Trailing Stop" or "Chasing Stop."  Here's how they work.

Stop-Loss
As its name implies, the stop-loss is meant to bail you out of a bad trade with minimum loss.  In my experience, a judiciously applied stop-loss has been more than made up for by the next successful trade.

Where you set the stop-loss is basically determined by how much you are willing to lose before closing out a bad position.  One school of thought suggests setting your stop-loss at 10% of the trade cost.  That's okay, but I've always found it too arbitrary.  Far more effective is setting the stop just below support (or above resistance if selling short).  In my own trading, I normally set my stops a few ticks down or up according to Fibonacci support/resistance areas, as well as the progress of the Elliott Wave pattern I'm following.  Suggested stop levels are also included in our Wave Watch reports. You can also use a 200 and 50 day moving average, or SAR (Stop-and-Reverse) indicator, though I find these a little less reliable.  The "perfect storm" is when both Fibonacci support/resistance and the moving averages converge.  Darvas used what he called his "box method," which consisted of a series of tests and retests of support and resistance.  A study of his method shows that it had a Fibonacci basis.  

Trailing Stops
You apply trailing stops when you are in profit in order to protect it against reversals.  Applying trailing stops can be a little trickier than stop-losses.  On the one hand, you don't want to trail too tight, as you could be stopped-out prematurely.  On the other, you want to lock in your profit against a sharp reversal.   In this case, I'll still use support/resistance as my benchmark, but will set my stop a few ticks wider.  I'm still leaving myself the option of canceling my stop and selling (or covering) if the stock is really reversing, and protecting my profit if I can't put an order through in time.  

Another key to the clever use of trailing stops is volume.  If price and volume are diverging, it's a good sign a trend reversal is likely.  In this case, I would set my stops much closer to support/resistance.  Most charting software provides a few choices of volume indicators.  Particular favorites of mine are the Force Index, Money Flow Index (MFI) and my own Relative Volume Price Oscillator (RVPO) developed here at Market Harmonics.

How to Enter Stop Orders
Once you know where you want to place your stops, you can enter stop orders either on-line or with a call to your broker.  No broker fees are charged unless the stop is executed.  You can enter two different types of stop orders: market orders, or limit orders.  A stop market order tells the broker you want to sell if your stock falls to a certain price area.  The stop may be executed either at your price or as close to it as possible based on the best bid price at the time your price area is reached.  With the stop limit, the order becomes an automatic sell at the limit price.  

So, which is better?  On the surface, the limit order may seem to be the best bet.  In a suddenly sharp, reversing market, it probably is.  However, it's also automatic.  Since the stop market order is executed with more leeway, your broker may have held before getting you out at the trigger price, particularly if the reversal was of relatively short duration.  You'd still be in the market.  Here again, volume can be a good ally in deciding what to do.  If volume and price are trending strongly together, you're probably safe with the stop market order.  If volume is diverging against price, the limit is better.  If in doubt, go with the limit.  You can always get back in the market if you're prematurely stopped-out, and with some extra cash to do it. 

Some traders apply "mental stops," meaning simply that they'll put through their own sell (or cover a short) when the stock reaches a certain level, without having had the order already placed with their broker.  I wouldn't recommend this, though, unless you are a very active, experienced, and disciplined trader.

I'm amazed at how few people use this protective tool.  Some argue that using stops prevents an investor from getting maximum profit, though I challenge them to say just what "maximum profit" is.  The real question is whether you are willing to accept maximum loss if your stock heads south.   And in this incredibly volatile market, a stop can be your best friend.