This document provides guidance on how to properly set stop losses when trading stocks. It emphasizes the importance of setting stops based on the volatility of the individual stock and maintaining a good risk-reward ratio. Key points covered include assessing factors like price, volume, sector performance and previous price history to determine a stock's volatility and where to set appropriate stop levels. It also discusses adjusting stops as the stock price moves up in order to stay in a winning trade for larger gains while avoiding guessing at price tops. Discipline in setting and adjusting stops according to this strategy is highlighted as important for success.
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THE ADAM MESH STOCK-COACHING PROGRAM
The Guide to Placing Good Stops,
A.K.A. “What Could’ve Been!”
The hardest part of trading stocks is knowing when to sell.
For starters, you must begin by accepting that you will never be
perfect. In an ideal world that was geared toward keeping the
average trader sane, you can just sell your stock and have it stop
moving. That way you would never have to deal with “what
could’ve been.” Chances are, when you sell a stock you will either
be thinking that you should’ve held as it has already gone higher
or you should have sold it earlier. That’s just the way we are
programmed. The sooner you can accept that you will never
make the “perfect trade,” the sooner you can focus on making big
money.
I often ask my students, what would bother them more: Seeing
their stock go up without them in it or having it go down with them
still holding. Typically, it is the latter that they fear. A wise man
once said, “You will never get hurt taking a profit.” I agree with
that sentiment. There needs to be a balance where you give a
stock enough room to keep you in it if it is going up and keep the
stops tight enough to get you out before a big down move.
As with everything in trading, the key is discipline. As long as you
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develop your strategy for setting stops and stick to it, you will be
giving yourself the best chance at success. If you buy and sell at
random then you will not be trading stocks for long. I know a guy
that just learned firsthand why it is so important to remain
disciplined. He had no problem buying stocks but when he did, he
got scared. So he would set his stops way too tight and get
stopped out right away. He got so frustrated that he stopped
putting stops in and then he had a stock move three points
against his position him. If he would’ve kept putting in the tight
stops he would have been around even and if he would have not
put stops in at all, he would have actually been up a lot. Instead
he acted randomly, without a plan, and ended up down money.
Now, the best thing he could’ve done was follow a strategy for
setting stops that would’ve allowed him to allocate a proportionate
amount of risk/reward to each position. He could’ve maximized
his results by holding the winners and dumping the losers. The
key is, knowing how to set those stops. Let’s find out…
A Stop Order or Stop Loss is designed for your protection. If the
stock is terrible and you’re not paying attention, a well-placed stop
is what prevents a small loss from turning into a major disaster. A
simple buy and hold strategy is no longer a viable option. One of
the main reasons I have so many students is that they bought
stocks and a couple of years later realized that their hundred
thousand dollar portfolio was only worth thirty thousand. The
market is like the ocean, it’s fun and exciting but if you are not
paying attention then it can be extremely dangerous.
Volatility
One of the key criteria for setting a good stop is assessing the
volatility of the stock itself. For example, if you were to set a stop
in Google (GOOG) at thirty cents below the market then you
would just be throwing away money. Google can have a bigger
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spread (the difference between the highest bid and lowest offer)
than thirty and you could be out of it seconds after you bought it. If
you are buying a stock because you believe it is going up then
you want to give the stock enough room to prove you right. If it’s
an extremely volatile stock then you need to realize that there is
going to be above average risk in the trade, which will require you
to space out the stop and give the stock room to move around. If
you are not willing to take on that risk then you should avoid the
stock.
If the stock is a slow mover then it wouldn’t make sense to give it
more room. For example, if the stock is at twenty and a huge
move would be two points then you might want to only take on
thirty cents worth of risk.
There should always be a good risk vs. reward scenario.
We’ll discuss risk/reward later, but for now let’s stick with
assessing the volatility. One easiest ways to determine a stock’s
volatility is to look at its trading history. Is this a stock that tends to
move three points in a day or would twenty cents be more likely?
What are the volume tendencies of the stock? Typically, higher
volume stocks are less volatile because there are more people
involved in the stock, therefore less fluctuation. When there are
less people involved there is more room for big moves. When I’m
talking about high volume vs. low volume, I would consider
anything over ten million high and anything around 500 thousand
shares traded per day relatively low volume.
Please understand that you can have a stock that only trades 50
or one hundred thousand probably because it’s not in play and
not going anywhere. These stocks are typically news driven and
subject to a random jump or drop. This is not the risk/reward
scenario that a beginner should be looking for. Price is another
factor that determines volatility. A higher priced stock simple logic.
A 10% move in a twenty-dollar stock is two points and a 10%
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move in a hundred dollar stock is ten points. That’s why I
recommend beginners start by trading stock within a 10-50 dollar
price range.
To trade a seventy or eighty dollar stock properly might require
more risk than you are willing to take on. Please understand that
a twenty-dollar stock can move points in a day or more but it is
more common in a fifty-dollar stock. Notice the chart below. This
is a news-driven stock that often focuses on a binary event (FDA
approval). In trading there are exceptions to every rule.
The last thing I want is for you to think you are completely safe
trading a twenty-dollar stock simply because it is a “twenty-dollar
stock.” However, the more factors going your way, the more likely
you are to correctly determine the volatility of the stock.
The volatility of an industry and sector of an individual stock is
also going to affect the volatility of specific equity within said
industry/sector. Similarly, a twenty or thirty-dollar stock in the oil
industry will tend to move around a lot more than a similarly
priced stock in the brokerage industry. Oil is constantly in the
news and the stocks trade in a wide range. If you are watching a
stock “in play,” in a given sector then you need to realize that
there will probably be a lot of movement in that stock relative to
the sector’s movement.
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For example, a few years ago, when Microsoft announced they
were buying AQNT. AQNT moved from approximately 35.00 to
63.00, which caused related stocks like VCLK and TFSM to surge
as well. When a sector/industry is in play, the stocks are going to
have more movement than normal. If you bought VCLK in the
previous example and did not give your stop enough room then
you probably would have been shaken out and missed a two point
up move. So remember to evaluate: previous history, price,
volume, and industry/sector performance to determine the
volatility of the stock and subsequently where to set your stops.
Risk vs. Reward and Stops
Everything in trading is risk vs. reward. You never want to
have proportionate risk to reward, meaning, it should not be a
1:1 ratio. You want to risk one point to make four or more. After
you have established your resistance level, you must determine
whether or not the trade is worth it to enter.
For example, if a stock has just gone from 25 to 29 over a 2-week
period and there is a clear resistance level at 30 then the trade
doesn’t make sense. You have levels at 25 and 30 and the stock
is at 29. So you would be risking 4 to make 1. Because of the
proven resistance, we would not enter that trade (long).
Now, let’s say the stock clears 30 and the next level of resistance
is 35. Now we may have a trade. We can buy at 30 and look to
set our stop below the level. If it’s a fast moving stock then we
might set our stop around 29 and risk 1 to make 5. If it moves 2
points every 6 months then we might only give it .50 cents. The
goal is to keep the risk proportionate to the reward. Now when the
risk vs. reward changes we need our stops to change as well. If
we bought this stock at 30 and it went to 32 then we wouldn’t
leave our top at 29. If the next stop was 35 then why risk 3 to
make 3?
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We want to maintain a good risk vs. reward ratio; so in this case,
we might move our stop to 31. We are risking one to make 3. In
this example, our worst-case scenario is now making a point.
Remember, good stocks keep you in them, if you place your
stops correctly (adjusting for volatility) then you will stay in.
By moving your stop on an up trending stock, you are
ensuring a profit; While at the same time, not guessing the
top. You’re giving yourself a chance to stay in for a big move
without risking your profit!
This will take practice and discipline; make no mistake. The
system works, it’s up to you to make it work suitable to your
investment objectives and risk tolerance. Your greatest
challenge(s) will be to set Stop Loss orders; the consequence: A
“Hope the position will eventually move in your favor.” We’ve all
done it. Remain disciplined!
ALWAYS CUT YOUR LOSSES WITH A PRE-DETERMINED
STOP!
Here’s an example of what a good stock looks like:
Once it starts to go up, a “good stock will keep you in it.” By
placing your stops strategically below significant levels you
could’ve been in this stock from 60 to 100 or even 120. This
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strategy also allows you to keep your sanity. By staying
disciplined and taking the same approach every time you don’t
miss out on all of the high flying stocks and you don’t get caught
in all of the one day wonders that return to earth minutes after
blasting off.
When setting your stops, remember to allow for a good
risk/reward ratio and to maintain that ratio by adjusting your stops
when the stock moves up. Obviously you should not be adjusting
your stops on the way down. When the stock hits your stop then
you are out and can look to reenter at a strategic point.
Modern Day Tips
When you are setting your stop, you have to use some creativity.
There are so many computer programs permeating the markets
that you must allow for the volatility they cause. If you have
programmed stops in at the price of 30 then as soon as that stock
hits 30, thousands of orders are triggered at once and the price
will drop. This does not mean that 30 is not a resistance level. It
means that if it does break below then it will come right back up.
That’s why you can’t set your stop at 29.99. Use the volatility of
the stock to determine where to set the stop. Some will be .25, .50
or a point below.
Let’s expand on this modern day theory. Sometimes they will
bring the stocks down in .25-cent increments. This means your
stop should be slightly below that. So if your level is at 29.75, put
your stop at 29.70, instead of 29.50, do 29.40. This extra ten
cents could keep you in the stock and have you make an extra 3
or 4 points.
I knew a bunch of people that traded HANS. It once had a critical
35 level. Some beginners put their stop at 34.90 and some of the
more experienced traders put their stop in at 34.40 (based on the
volatility and risk/reward). The stock hit 34.87 and then turned
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back around. All of the 34.90 stops were knocked out which was
unfortunate.
Because the stock went to 40, fifty cents cost people five dollars.
On one hundred shares, they cost themselves 500 and on a
thousand shares they cost themselves 5000. Remember this
when deciding where to set your stop. If you set your stops
correctly and avoided that little shake out move then you had
clear sailing to 45.
FAQ on Stops
1) What happens when a stock goes through a 52 week high?
Use the old high as a new downside resistance level. If the
high was 50, that is now your base. After assessing the
volatility and risk/reward, you can set your stop at 49.40 or
48.70.
2) How do I set a stop in a stock that has gone straight up and
there is no recognizable resistance level that is close to the
current price?
Great question; if you just have to have in on the high flyer
that has gone straight up then use a day slightly below that.
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3) If a stock has bad news after the market closes I will just be
stopped out at my price, right?
Wrong. Stops only work from 9:30AM to 4PM so don’t
assume you can hold a stock with imminent news pending
and your stop will protect you. Stops only work during market
hours. If you have a stop limit then it will stop trying to sell
beyond your limit but that can be dangerous. A market stop
will get you out of a stock at the first available price after
hitting your stop (which could be significantly lower if bad
news happens over night). This hurts if the stock shoots right
back up but can save you a lot of money if the stock
continues lower.
4) What do you think of trailing stops?
I don’t like them, especially for a beginner. Here’s why. Let’s
say you own a stock at 40 and have a .50-cent trailing stop.
If the stock goes to 41 and then down to 40.50 you are out.
It’s just starting to move for you and get stopped out? It
doesn’t make sense. You no longer have the proportionate
risk/reward that you want.