Monday, October 8, 2012

Trade Management Part 1: Stop Losses

MetaStock SPRS Series - Week 89 - TechniTrader® Stock Discussion for MetaStock Users - Trade Management Part 1: Stop Losses - October 8, 2012
By: Martha Stokes C.M.T.

Any time I hear a trader say they don’t use stop losses because they “don’t work” I know immediately that the trader is using one of the old-fashioned, outdated stop loss strategies.

As a trader you need to remember that the stock market and all the other financial markets are continually evolving, changing as they adapt to new technology.

In the past decade there has been unprecedented technology changes to the internal structure of the stock market. That has caused changes to the Market Participant Groups, and its cycle has changed due to the new groups that have emerged that were not present a decade ago.

So you really need to consider if the information you are getting from the internet, websites, gurus, news media, technical analysis books, periodicals, etc is CURRENT or outdated.

One of the most common problems retail traders face is that they are unwittingly using outdated theories, strategies, and trading systems. If you are having troubles with stop losses then you are either using an outdated strategy OR you are not setting the stop loss properly for your trading style, the trading strategy you are using, and the chart patterns for that stock.

In the “old days” when retail trading first began and online brokers first emerged on the internet providing online trading services to mostly day traders, a percentage stop loss was promoted.

This came from the even more archaic stop loss approach used in the 20th century for longer term investments.

In those days, there were no PC computers so there were no charting programs like we have today. The stock market was a fundamental market, so a percentage stop loss for the average investors made sense. Since no average investor had even heard about technical analysis, a percentage stop loss was the easiest way to protect the investor from a catastrophic loss.

Nowadays, a percentage stop loss merely invites whipsaw action due to those who use that common and popular stop loss strategy to trade against you.

The most popular stop loss percentages were either 8 or 10%. Since only a scarce few professionals were using technical analysis, these stop losses worked reasonably well during the 20th century but for most retail traders nowadays percentages pose huge risk. In fact the percentage stop loss increases risk because there are Algorithms searching for such cluster orders.

Cluster orders are orders that ‘cluster’ around a certain price point unnaturally. These are prime targets for automated orders based on algorithms designed to find these clusters and trade against them.

Let’s use IBM a company that is ever popular and with which most every trader is familiar.

Where should you place your stop loss?

Archaic convention says 8-10%. So let’s use the 10% to be “on the safe side” or more conservative.

That would put you at about 185-186 right smack in the middle of the sideways action. If the stock retests the short term low, then your stop would be taken out as so often occurs.

Chart 1

For longer holds you need to be under strong support, not above weak support where the 10% stop loss places you. You are smack in the way at 10% and yes your stop would be taken out on a sudden collapse of this stock.

For a long term hold the support level is actually way below where the first round of quiet distribution occurred, way down around $150.

Percentage stop losses are an outdated antiquated strategy. If you are still using this old-style stop loss you need to update your methodology. Use a current stop loss technique that works with the modern automated marketplace, the more diverse groups of market participants, and the technical as well as fundamental aspects of trading.

If you are a technical trader and you are using percentage stop losses, you are using a fundamental method for stop losses. The two do not go together.

If you don’t use stop losses at all OR worse “have it in your head,” then you are gambling.

At some point, you will take a catastrophic loss.

Stop losses are part of trade management, risk management, and common sense trading.

Trade wisely,

Martha Stokes, C.M.T.
Member of Market Technicians Association
Master Rated Technical Analyst: Decisions Unlimited, Inc.
Instructor and Developer of TechniTrader® Stock Market Courses
MetaStock Partner

©2012 Decisions Unlimited, Inc.

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