3 Tricks to Stick to Your Stops
I’ve told you in the past that it can be good to be a loser in the stock market (if you missed it, click here to see why). Today, I want to show you three effective ways to set stop losses on your trades.
First, a little more on why being a good loser matters…
Put simply, some of the most successful traders I know are also the most psychologically prepared to cut their losses and book gains early. They enter a trade knowing what their “pain threshold” is, and when it’s time to walk away.
Honoring your stops sounds easy when you’re dealing with hypotheticals, but when real money is on the line, it’s rarely as simple as selling off shares once they reach a preset level. Selling a position that you’re mentally committed to is tough. Today, I want to touch a bit on the mechanics behind why stops work – and show you how to make sure that you’re not leaving money on the table when you get stopped out.
Simply put, a stop loss order is a way of protecting yourself when the market moves against you. It’s an order that triggers when shares fall below a specific, predetermined price (in the case of a short position, stops trigger when shares move above a predetermined level). By putting stops in place, you’re essentially locking in the maximum loss you’re willing to take on a position before you throw in the towel.
It’s important to remember that, for traders, stops aren’t an admission of failure…
Instead, they’re a way to protect against contingencies that may spring up. Experienced traders always have a failure rate built into their trading systems – they know that even in a perfect world, a given percentage of trades aren’t going to play out as planned. That’s the key differentiation I’ve noticed between aspiring traders and million-dollar per year traders.
The million-dollar trader knows that losing is a necessary evil of trading.
Once amateur traders realize that, the mental side of honoring stops becomes much less daunting. Understanding the virtues of being a good loser is only half of the equation.
The other half is knowing where to place your stops.
After all, traders who honor poorly placed stops aren’t going to be long-term winners.
Keep these three factors in mind when placing your stop, and you’re much more likely to find success even when markets behave like they have in July…
1. Stops Should be Technically Relevant
Stop loss levels shouldn’t be arbitrary – just because you’re willing to lose a maximum of 5% on a stock doesn’t mean that a 5% stop loss is a good idea. That sort of investor-dictated stop completely ignores the cues that the market’s giving you about the likely price behavior of the stock you’re trading. Instead, your stops should be technically relevant.
What that means is that you’re placing stops at price levels that represent a maximum deviation from the technical pattern you’re trading, not some random loss you’re limiting yourself too.
In practice, that generally means placing stops right under important support levels. That way, once buying support has failed for your setup, you’re automatically out of the trade. Keep in mind that the support level you choose can coincide with a maximum risk you’re willing to take; technically relevant support is just the more important of the two.
2. Stop Outs Should Be Material
All too often, I see cases of traders who do a good job of honoring their stops (and closing their positions), only to leave money on the table when the trade rebounds. The problem is that they’re being too strict with their stops. Remember, support prices aren’t absolutes – a stock can easily move a few cents below the support level you’ve spotted without being a “failed” pattern just yet.
To combat that, I recommend avoiding hard stops (i.e. stops placed with your broker, that trigger automatically). When possible, you should be watching the near-term price action of any stocks you’re trading. That way, you’re able to override your specific stop price if shares fail to penetrate it by more than 1%.
3. Stops Should Hold You Accountable
If you’re having trouble pulling the trigger when it’s time to sell a stop out, you need to be accountable to your stop loss orders. One of the easiest ways to do that is to be explicit about them: consider posting your trading levels on a public forum like a blog or Twitter. (This may not be an ideal solution for traders of smaller names who don’t want to “show their hand” to those on the other side of the trade.)
A more private solution is to keep a trading journal that clearly defines your stop loss price for any stock. This requires you to review your trades that fell below those levels.
There’s no question that taking a loss is the trickiest part of being a trader – but in my experience, it’s also the common thread between the most successful traders I know.
Master the art of the stop and you’re well on your way to generating substantial gains in any market…
Have a great weekend,
Jonas Elmerraji, CMT
P.S.: I mentioned that Twitter is a great place to post trading ideas – you can follow my trading thoughts in real-time on Twitter @JonasElmerraji.
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