Using the “what goes up must come down” gravity theory, the risks of a sell off increased greatly with the April rally. The $VIX fear gauge showed complacency was at its highest point (the VIX was at its lowest point) since the Lehman Brothers collapse that started the current financial crisis. Hindsight makes it clear that a pull back was due eventually but fighting the trend and guessing the market top is never a prudent solution.

The combination of news events increased investor anxiety enough to do something. Thursday’s sell-off was the result. And although the market has since re-stabilized, the intraday trading that went on taught some valuable lessons.

Standing stop loss protection orders are one market tool that is often more art than statistical science. An exit strategy is absolutely necessary to control risk – but the devil is in the details. A stop too close may get knocked out in normal fluctuations while a stop too far away doesn’t provide solid financial protection on a move against you.

Typically traders will keep moving the stop exit orders up when their positions are moving favorable to lock in gains. With the recent stock market run and a yearlong rally an abundance of sell orders laid below. The conditions were set for a snowball to roll down the hill gaining speed from standing orders on the books to SELL.

The proliferation of high frequency and program trading has taken over the markets accounting for more than 60% of volume each day. Those technology and speed advantages are designed to profit from the tiniest inefficiencies to arbitrage between markets or exchanges. They also kick in when buying or selling trends develop to jump on to ride the wave – trades like that can happen in minutes.

That’s part of the reason that I don’t provide rigid stop losses in for my Resource Trader Alert readers.  I keep an eye on the price action of all of our positions and when the time comes to take action rest assure that I’ll issue an Urgent Trading Alert.  Clearly it’s better to keep an active eye on the market instead of a standard stop/profit targets – and our track record can vouch for that.

Where to Go from There

But if the stocks that have stop loss protection aren’t even safe, where should investors turn? The panic and volatility should be a reassurance that when all heck breaks loose, as it does from time to time, commodities are a great place to weather the storm

With paper currency and stock certificates on the decline, gold is a natural alternative. Trying not to sound like the barrage of commercials for coins on TV, it’s safe to say that hard assets hold value in uncertain times. As such, gold rose last week and is set to make new all time highs.

The flight to safety rally into Bonds and the US Dollar last Thursday should be watched for signs of stability. The move back down to the technical breakout point from Wednesday can indicate the end of equity and corresponding overall asset decline. Bonds below 120 and the Dollar at 83 are key levels to follow.

Sincerely,
Alan Knuckman
Penny Sleuth

May 12, 2010

The Dangers of Stop Losses was originally featured in the Penny Sleuth.

These aren’t dumb questions. In fact, stop losses can be more complicated than you think. That’s why I’m going to spend some time discussing a couple of strategies today. If you learn how to manage your stop losses wisely, you could greatly improve your trading success!

Before you set your next stop loss, ask yourself the following questions:

What is the time frame for my trade?

How much risk do I want to take?

The first question is relatively simple. Are you trading, or are you investing? For a long-term investor, setting a set stop loss at 25% or so is a good idea to protect your capital. This gives your investment plenty of room to rise and fall, without stopping you out before the stock reaches its potential

If you are trading — that is, if you are planning on holding the stock anywhere from a couple of days to several weeks — the time frame is obviously short-term.

With short-term trades, I like to base my stop losses close to new areas of support. That means after a stock has made a significant move to the upside, I will look at where it is beginning to consolidate. Check out the chart I made for you below. You’ll see I’ve drawn blue and pink horizontal lines directly below new areas of short-term support:

Now on to the second question: How much risk do you want to take? If you are a conservative trader, you will want to set a tighter stop loss. I’ve drawn the conservative stops in pink…

Let’s say you bought this particular stock right at the left edge of the chart. A more conservative trader would probably set his losses a couple of cents directly below support (the first three pink lines). As you can see from the chart, the conservative trader would be stopped out of this position after the break of support at the left edge of the third pink line.

On the other hand, if you are willing to take more risk, you could set your stop a bit lower (blue lines). This would give you the chance for bigger gains. There would also be some drawbacks. Obviously, you’d be exposed to additional risk should the stock drop unexpectedly. And there’s also the time factor. You’d probably be in the position longer than you would if you had cashed out with a more conservative stop.

I think it’s also important to note that stop losses aren’t a one-size-fits-all deal. When I set them, I take into account everything from how fast the particular trend is moving to liquidity to fundamentals that might help me mitigate risk. What’s important is that you pick a stop loss level that you feel comfortable with.

Having a set stop-loss also helps traders curb their dangerous emotions. It’s tempting to let a stock ride after a bad day, then another, and even another. Your brain will justify bad decisions like these because most investors are reluctant to sell a stock for a small loss. However, if you have a firm stop loss in place — and if you are confident in your market strategies — you will have the opportunity to greatly reduce your trading losses, and improve your overall returns.

Sincerely,
Greg Guenthner
Penny Sleuth

April 30, 2010

One Easy Step to Improve Penny Stock Returns with Stop Losses was originally featured in the Penny Sleuth.

As I write this, we’re sitting at the top of a historic rally; since the market found its most recent low in March, the S&P 500 index is up nearly 34%. And more and more cautious investors are becoming nervous. After all, how much higher can the market go in such a short time period?

That building sense of investor queasiness could turn into a self-fulfilling prophecy when all of these jumpy stock buyers become sellers at the first sign of a pullback. Just take a look at the chart below:

We may be just 4-5% away from the next technical stumbling block traders are watching out for – the 200-day moving average of the S&P 500.

As the S&P climbs nearer to the red line, you can expect technical analysts to watch intently. Trading off these movements is their bread and butter. What that means for fundamentals guys is that we should be watching our portfolios very carefully right now.

But there is one very good way to protect your gains right now – it’s called a stop loss.

Basically, a stop loss (or stop, or stop order, etc) is an order with your broker to sell your shares in a particular stock automatically when its price hits a specific level. That means if your shares of Stock A are up 30%, you can set a stop loss to trigger when the stock drops to 25%, guaranteeing your minimum profit.

While there are several different types of stop losses, these three flavors are worth knowing about:

1. Stop Order: Triggers once your stock reaches a specific target price, the stop price.
2. Trailing Stop: Triggers at a specific change in price, measured by either percentage points or dollar value.
3. Stop Limit Order: Similar to the stop order, except for the fact that a limit order is triggered once your stock reaches a specific target price. (i.e. sell high, and re-buy low)

Clearly, the biggest benefit of placing stop losses is the fact that you won’t have to lose sleep over your open positions – if the stocks you own take a big dive, your positions will sell off before any major damage is done. That’s a pretty compelling case for using stops.

Still, that’s not the whole story…

Drawbacks of Stop Losses

The biggest reason that people lose out on stop losses is through short-term fluctuations in stock price. If you have a stop set at 5% below a stock’s current price level, and the stock swings 10% in the week, your stop will trigger and you’ll miss out on the stock’s rebound. As a result setting your stop losses intelligently is essential.

But exactly where to place your stop-losses is another tricky bit of business. It takes even the most skilled traders a good bit of trial and error to learn what works when it comes to setting stop losses.

If you’re a believer in fundamentals, it’s best to think of stop losses as profit keepers. You should place them at the level of gains you’re comfortable walking away with. If one of your positions is up 20%, 15% gains may be the least you’re willing walk away with – if that’s the case, it makes sense to put your stop losses there.

Even if you’re a fundamental investor, stop losses can be most valuable when they’re combined with technical analysis (using chart patterns to determine where a stock’s price is going). After all, technicals are what drag fundamentally sound companies down during a bear market. Unlike with fundamentals, where stop losses can be considered “profit keepers”, you can think of technical stop losses as insurance – a way to ensure that your stock won’t go into freefall.

Stops can be very useful when they’re placed under a stock’s support level (the price level that a stock has trouble falling below). That’s because to a trader, a price level below support generally means that the stock could be breaking out much lower.

Don’t Stop the Stops

Whatever your investing strategy, stop losses can be a valuable part of your investing toolbox. That said, using stop losses and other more complex broker orders can be tricky for beginners – always make sure you understand what you’re doing before you commit money to a trade. Here at the Penny Sleuth, we’ll keep doing our best to provide you with an investing education.

Cheers,
Jonas Elmerraji

May 7, 2009

Use Stop Loss Orders to Protect Your Gains was originally featured in the Penny Sleuth.