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Determine A Proper Stop Loss
By Jobo Smith
Figuring out the proper stop loss when trading, whether experienced or novice, is always a tricky subject. One thing is for sure, if you don't use one and try to become a trader, there is almost a 100% chance you will lose a significant amount of money. Even using stops, if they are inappropriate, will result in net losses no matter how good the stock pick is. In addition, adding positions before market moving news events occurs can assure increased volatility and increased odds of stopping out. The main thing to keep in mind is CURRENT MARKET CONDITIONS - I cannot stress this enough. Not what the Dow Jones Average is doing, what many stocks are doing overall. What is the volatility level - are they slow and steady or whipping up and down on the slightest market move? This makes a huge difference is not only your stop, but the risk level involved. Most people assess risk by the amount one can lose. What almost everyone fails to consider is the ODDS of that loss happening. While there is no sure fire way to figure out odds, if you watch what other stocks are trading like you can get a pretty good idea. If conditions are calm, you might be able to use a smaller stop - a 30c stop has a 30% chance of getting hit for example. When conditions are frantic, a smaller stop is almost assured to get hit - meaning the 30c stop has a 98% chance of getting hit even on the exact same name. The way you figure the odds is somewhat straightforward. Look at the average range high to low over the last 20 minutes. Do not pick the most calm period of time, as this tends to not stay constant. If current times are super calm, go back on the chart to a more volatile period for the day and then figure the range. It does not have to be exact, an approximation is fine. Once you have this range, that is your MAX risk. What we want to do is to lower this max amount to a lesser level. This can be done 2 ways. The first way is to watch the pattern of trading behavior on the chart of the day traded stock - when it reaches a prior high level, does it push through and run some, or does it barely touch, then retrace (sell) down? If it tends to push (last few times it reached a high turn point), then its ok to buy the stock on strength. If it tends to fade or try to sell, better off to see it push, then put your order 1/4 of the range you computed earlier, lower than the high its at now. So if the range was 1.00, and the stock was at 40 now, you would put your order at 39.75 to go long. You will miss some names like this, but resist the urge to chase. If the pattern is on a lot of names (by eyeballing) you have to be especially careful. The second way to lower the risk is to split your order into 2 parts. So if you want to buy 500 shares, only buy 200 now. Wait until it pushes a decent amount up (meaning it has pushed enough that it has moved past the fade the breakout move area), then look to add the other 300 on a 5 or 10c dip. Move your stop up .45 now (assuming you had a 1.00 stop to start) on all of it. The other alternative, if the market tends to fade the push moves, is to buy 200 shares now, then put the balance of your order .25 above your stop (assuming it is 1.00). The max stop remains the same on all shares. The difference here is if market conditions get poor for going long for a period of time, you are going to lose a lot more averaging when its selling because you will get filled on the add, then stop out 2 minutes later on all of it. The way around this is to simply cut back size - when the market gets unpredictable, play ONLY 1/2 normal size or less until it starts to act more predictably. The name of the game is preservation of capital first and foremost (hence the stops), but second its to avoid easy loss situations. While its impossible to tell when conditions improve unless you are actually trading, there is nothing wrong with playing less shares until you see it look better over time. |
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May, 2012
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