STOPS: Why and How

Too many e-mails concerning stops, stop placement and different aspects of this topic to omit it. Several articles will be devoted to this crucial part of trading.

A discussion of stop losses usually involves three parts. The first part is an explanation of the absolute necessity of applying a stop loss to any trade. I am going to assume that the reader knows very well that risk control is a crucial element of their survival in the markets. The second part concerns psychology and discusses the practical tricks that ensure a trader never goes into a “reasoning mode” and blows his or her stop. I'll get to this later. The third part is purely practical – where should a stop be placed? What factors should be considered? How should a stop be trailed when a trade moves in one’s favor? A practical aspect of placing stops is the topic of this article.

One very common notion says that a stop should be placed in such a way that it limits your loss to a certain amount – 1 to 2% of your trading capital is typically recommended. While limiting your losses to this amount is a sound recommendation, this approach is flawed if market movement is not factored in. Here is why: the market has no idea about your capital, your risk tolerance or even the fact that you are in trade. It moves by its own rules and patterns, and those patterns must dictate your stop placement. In other words, it’s a signal of a trade failure that tells you “Get out!” We will be back to the 1 to 2% rule later; at this point let’s define your major rule for a stop placement.

Your trade is stopped out when a reason for a trade is no longer there.

Let’s see how it applies in practice. Our first example assumes you are trading a Cup and Handle type of breakout (see Fig 1):

Fig 1. Cup and Handle



Let’s look into your reason for a trade, to find out what defines a failure. A Cup and Handle is a breakout setup that triggers your trade at the moment when a ‘rim’ is broken. A ‘handle’ bottom forms a higher low compared to a cup bottom, showing its closest support. The break of resistance, while holding support, serves as your reason for your trade. It means that if a trade reverses on you and breaks the latest support, your original reason for the trade is no longer there, and your trade is stopped out. That’s why the stop level is placed just under the handle’s bottom on Fig 1.

Let’s look at another example: a reversal trade off a Double Bottom (see Fig 2):

Fig 2. Double Bottom





In this case your trade is based on an assumption that a stock has formed support by testing it twice and is poised for bounce. Obviously, a break of this support renders your rationale as invalid and, therefore, a stop has to be placed under this level.

The two examples above refer to chart formations; but the same logic applies to any other approach. For instance, if you trade off technical indicators and use, let’s say, a stochastic oscillator, a reading below 20 is an entry signal for a reversal trade. In this case, if a stock pauses instead of bounces and a stochastic reading goes lower, you read it as a “no bounce” signal and close the trade. Notice that the same logic applies even to the trades based on fundamental data: remember the famous saying “If you buy a story, you have to sell when a story changes”?

The next aspect of a stop placement is a trailing stop. It applies to a situation where a trade moves in your favor and pauses, forming the next resistance. If you are a scalper, you simply take your profit at this point. However, if your objective is to let your profit run, you will want to protect your profits from evaporating. This is where a trailing stop comes into play, and the logic of its placement is very similar: it moves to any new support formed by a stock on its way. Here is the simplest example of such trailing (See Fig 3):

Fig 3. Stop trailing





If a stock formed a new higher low after the first stage of movement, this level becomes a new support and serves as an indication for a new stop level.

Now, armed with the logic of a stop placement you can apply it to any trading strategy you employ. And what about that 1 to 2% rule that we mentioned at the beginning of this article? Really, think about it. What do you do if a chart dictates a size of a stop that exceeds your risk tolerance? You factor it in by position sizing. Let’s see how it’s done. Assuming your trading capital is $30,000 and you want to keep your losses on any given trade to within 1%, you limit your losses to $250. If your trading lot is 1,000 shares and your setup shows a stop level as .25 cents, you are fine. If, however, a stop level dictated by the setup is .35 cents, you simply decrease your amount of shares for this trade to fit your risk tolerance – in this case to 700 shares. Do not forget to make sure your stock is liquid enough to absorb your shares – if a stock is too thin, you will need to factor in possible slippage, decreasing your shares even further.

Now, granted – this way to place and trail stops is very common and overly simplistic. In reality, everyday trading employs more sophisticated methods than utilizing this “common knowledge” to enhance your edge. When a strategy is widely used, it can become a subject of “contrarian trading” – an approach that puts you on the Smart Money side as opposed to the Public side. This strategy is going to be the subject of the next article.

Death by a thousand cuts?

One of e-mails I recieved on a previous article deserves a separate post since I hear this question often enough.

It essentially asked "Isn't scalping a way to death by 1000 cuts?" Well, if you lose money trading, you lose it - scalping or not. What it comes to is whether you got good at trading, whatever your style is, or not. With scalping, you will lose slowly, in small increments - until you learn to win. In any other trading approach you will lose probably faster, in bigger increments - until you learn to win. If you go through "grinding it out" learning curve where losses are practically unavoidable, it's imperative that you keep them under control so you are still in the game when the critical mass of knowledge and experience is reached. In this sense, scalping is doing exactly this: since the risk control is very tight, it slows down the rate of losses thus giving you more time to learn.

Sure, slow bleeding is bad. I, however, fail to see how it would be better to blow up one's trading account in a few broad strokes. Maybe it feels more heroic, but you simply don't stand a chance to collect enough lessons (each loss is a lesson, right?) if you experience fewer losses of a bigger size. Capital preservation is the name of the game for the newer trader. If losses is inalienable part of this stage of learning process, my pick would be small ones.

As You Name the Boat, or What Is Scalping - Part II

Before I got distracted by the great weather that lures one outside, I promised to give my definition of scalping. That's the thing with promises - sooner or later you gotta keep them. So, let's do just that.

First, some simple definitions. There is such thing as a leg of the movement. Price moves in stages, or legs - advance, pullback, advance (let's talk in terms of long position, simplicity sake). Each advance is a leg.

Another important thing to define is pullback. For our practical purposes in the case, pullback is not a simple price decline. It's important to make a distinction between meaningful price retreat and noize. We will go deeper into that when in the future we discuss such thing as setup structure. At this point let's say: pullback is a price retreat that takes price back to entry point or close to it AFTER hitting target level or close to it. Noize is that meanigless dribble - cent up, cent down - that creates an impression of activity but doesn't jeopardize any support or resistance levels. This distinction is important because if you don't make it, you will dump your trade on a first sign of price retreat, and more often than not will exit a valid trade while it's still valid. Again you can see how our definitions define our actions.

All this brings us to the definition of scalping.

Scalping is a trading approach where a trader takes the profits at the first leg of the movement, not letting the price to pull back.

As a trading style, scalping is based on assumption that the first leg will be made successfully by more stocks than the second will. Think of it as the race where all runners are going to reach 1 mile mark. Weakest ones will drop out there; some more will drop out at the next mark, and the process will continue until just one "last man running" is left. So, if you want to bet on the biggest winner, you are going to try and figure out this strongest one. Your payout will be huge if you succeed but your chances to win this bet are not great. If you, however, want smaller but surer bet, you will be betting on those that make the first mark. You will have small wins, but your percentage will be great as you will be right in a lot of cases. And that's exactly what scalping is about. A lot of smaller profits get booked; immediate gratification keeps your moral high; your account experiences slow but consistent and confident growth.

Are there tradeoffs to this style? Sure, just as to everything. Can't have yin without yang.

If your stock moves way beyond your exit point, you are going to have a case of "scalper's regret". It's going to happen often, and it's going to bother you. Gotta learn to live with that. Self-irony helps. My favorite is (after ABCD goes couple dollars and I am out with my 30 cents), "ABCD just phoned, made evil laughter sound, called me an idiot and hang up". Another drawback is, while those smallish profits add up nicely, this approach won't let you get rich quickly (I can hear howls "awww how disappointing"). This is "trading for a living" approach, not "get rich quickly" one. Sorry again, gold-diggers. More drawbacks? Try this: booking profits consistently is addictive. Don't know about you but I can live with this addiction.

If I went into tradeoff issue, would only be fair to list advantages too, wouldn't it? Let's. Steady consistent profits; high level of confidence; worry-free mind; staying liquid, ready to pounce on the next hot play or clean setup; ability to sustain you through the sideways market when there are no clear trends.

OK, one thing still remains unanswered. Where is that price level that defines first leg of the movement? How does one know first leg is about to be completed? Most often it happens around the level where profit roughly equals your initial risk. This is what we call "1:1 risk/reward ratio". Obviously, for such level to be found objectively, one needs some criteria for initial risk (you can call it stop size or stop placement, same thing). This is where we go into the territory of the setup structure, the subject of one the following articles. One quite important thing to realize at this point is, scalping is NOT a trading system - in a sense that there are no setups specific to scalping. This obviously follows from the definition for scalping that I gave earlier. If you go for profits taken at 1:1 level, then the only thing that is going to show you where that level is is your setup which defines the size of your stop (initial risk). And in this sense scalping can be utilized within the framework of any trading system - whatever setups you like, know, can read successfully, have feel for, you can use for scalping.

Although the concept of setup structure is not purely scalping related, I will try and make references to scalping applications when discuss it, to round this topic up and tie loose ends.

As You Name the Boat, or What Is Scalping

There is this Russian cartoon named The Adventures of Captain Vrungel. The characters set out for a deep sea trip and name their boat Victory. As the boat pushes off, they marrily sing "As you name the boat, so shall it float". Two first letters immediately (and unknowingly for them) drop off turning Victory (in its Russian equivalent) into Disaster.

Funny as cartoon is, this is what happens when we define things for ourselves. Our definitions lock us into certain way of action that are defined by our definition. I am not implying anything esoteric here, rather quite straightforward things like if you decide that walking involves leaping ahead at each third step, that's how you are going to walk. To you it may mean walking while side observers will see you as a hybrid of a human and a frog, won't they?

I start some of my seminars devoted to scalping as a trading style with question: What do you think scalping is? How would you define it? (Well, actually I start seminars asking "Are you in the mood for some trading topics or let's go to the nearest bar?" but that's irrelevant). Then I offer several possible definitions for attendees to consider:

1. Scalping means taking profit on a first uptick, as soon as any profit is available.
2. Scalping means playing marketmaker - bidding and offering, trying to pocket the spread.
3. Scalping means closing the trade within a certain, very short time period - 3 minutes, 5 minutes, whatever.
4. Scalping means taking certain size of profits -= 5 cents, 10 cents, whatever.

All of those definitions find their fans - I see hands raised when I ask who is in favor of each of them. That's where the As You Name the Boat So Shall It Float kicks in. Whatever definition you adopt, that's how you are going to trade, right? Let's see what happens with any of those above.

1. Taking profit on a first uptick. Disaster in the making, IMO. If your stop loss is defined by the chart, it's going to be more than one downtick, otherwise you are going to be shaken out by simple noise. So, your stops are going to be bigger than your profits. So much for "cut your losses short". Losing strategy for sure, as it requires you to be right practically 100% of the time. Not going to happen unless you are one of those who win a lottery each time they buy the ticket.

2. Playing the spread. This approach surfaces now and then; there was even a whole book devoted to it (not sure what the rest of the pages beyond 1st described). Sometimes I hear from some prop shop traders that their management demands this to be the only strategy employed. This approach requires some very thick stock (think SIRI) that stays practically immobile throughout the day, trading big volumes at bid and offer, making rare ticks and returning back. This strategy (actually it's more of a trick than a strategy, I shall do a post on this distinction in the future) can work now and then; it fails misreably if a stock starts actually moving as you will be forced to take couple cents stop while your targeted profit is just one cent (or even less if you undercut bid and offers). Also, what does it all have to with trading? Of course, in accordance to naming the boat idea, let's define trading as exploiting the market movement - then this approach is something entirely different as it involves no idea of reading that movement and in fact shies away from moving stocks. Not my cup of tea.

3. Closing the trade within pre-defined very short period of time. Well, this one doesn't make much sense to me. What if your stock hasn't moved within that period of time? Or moved not enough to reward you for your initial risk? Or retreated but hasn't hit your stop yet? If you decide on a 5 minutes period and stock started ticking in your favor at the 4 minutes 55 seconds mark - do you get out, even though the move you aimed for has just started? Better yet: let's say your stock sits still near the high while the market drops for 5 minutes - isn't it a great indication of its relative strength? Why would you want to get out of it just because 5 minutes passed, even though it's more than likely to move up when the market bounces? Why put yourself on a clock, as if the market cares about how many times you enter and exit and is going to reward you for just taking positions? Once again, flawed definition will lead to a flawed trading.

4. Taking predetermined small profits. OK, your stock ticks in your favor. You even aligned the profit target with your stop - let's say your setup's structure (topic for one a separate post I think) dictated 7 cents stop, your stock moved 10 cents, things look logical and meaningful now. However, are you going to take your profit now in ANY case? Even if a stock show no signs of slowing down? No pause, no pace change in buying? Sure, scalper's regret is a natural part of scalper's life, but why set up yourself for it even though the way your stock trades shows the potential for more? There will be lean times when your stops are as numerous or exceed your profitable trades, why deny yoursefl some cushion while you are hitting it right?

OK, time for a question - what's MY definition for scalping? What name did I paint on this boat?

Next post will be about that. It's too nice outside, gotta soak in some sunlight and shoot some photos.

Oh, and by the way - if you went over my articles on scalping before or own my scalping course, thus familiar with my defnitions and my way to do it - you can still make some use of the idea of the post - the way you define things will define how things work for you. As you name the boat, so shall it float.

What do your photocamera, frying pan and stochastic have in common?

Have you ever heard "What a wonderful photo, you must have a great camera!"? Does it make much sense to you? If yes, you are not alone; for some reason it sounds reasonable. Let's try this: "What a wonderful food, you must have a great pan!" I bet this doesn't make sense at all, does it? Quite obviously, the pan is merely a tool which at best may limit or broaden the possibilities of tool user. It may not be as obvious in case with camera, simply because modern camera is extremely sophisticated gear enabling average user to take quite spectacular shots. Let's, however, set the simple experiment: Give primitive $150 Point&Shoot to a professional photographer and give state-of-art $3000 digital SLR to an amateur. Send them in the field for 1 day. Ask each to bring 100 photos. Compare the results.What's the point of all this? Well, both the photocamera and the pan, however different the level of sophistication may be, are just tools. They don't do the job themselves. They are as good as the person using them is. It's a nut behind the wheel, as usual. For now, remember this important distinction that higher level of sophistication makes it somewhat harder to see this point clearly.

Soooo... what does it all have to do with Stochastic? First of all, let me say it's not about this particular indicator. It's about Technical Analisys in general. Just how often have you heard and maybe said "TA doesn't work!" Or "MACD doesn't work" (insert any other technical indicator or study known to human)? Or, how often have you read yet another heated argument whether they work or not? Here is the deal: unless your computer is broken, they always work! As in, they do what they are intended to do. And this is where major misunderstanding lies: many think that TA is intended to bring profits. Wrong. Indicator is intended to indicate. Something. Anything.. As long as it indicates, it works. Yeah, but why doesn't it bring profits? For the same reason that the camera doesn't take photos by itself even so as long as shutter clicks it works. And for the same reason that the pan doesn't cook a dinner even though as long as it heats up it works. It is designed to provide you with certain tool - and that it does. How you utilize the tool is what defines success or failure. Returning to particular example of stochastic: it indicated the reading below 20%, did it work? Sure, it indicated what it was designed to indicate. Now, what do YOU do with it? Do you enter long for bounce? Do you wait to see whether the price doesn't bounce so you short for downtrend continuation? Do you add another indicator to get some combined reading? Rephrasing it all, it's about how you incorporate certain TA in YOUR trading approach. If you do it right, profits come. If not - this is your approach that doesn't work, not the TA. Or, you incorporated that particular indicator in a wrong way and some tweaking is in order.This all seems to be trivial when you go through this methodology of thinking and comparison; so why is it not that obvious from the get-go? Well, remember the thing about sophistication? In exactly the same way as it seems to be not so obvious in case with camera vs. case with pan, many of technical indicators and studies are being percieved as quite complicated (and they often are). Something so smart must be doing some serious work and lead to solid results... can I relax while it's working and harvest when it's done?Understanding of real purpose of TA is quite crucial for working out the right trading approach. It also leads us to interesting and somewhat controversial topic of trading systems. That, however, is a topic for another post. For now, let's agree: