The art of setting stop loss points

Updated

I have been meaning to write a post on setting stop loss points for quite a while now but as you readers know, never got down to it. Well, its raining outside and my plans for the evening are all drenched, and the glass of bourbon in my hand is egging me to write this post. Well, knowingly or unknowingly, I have disappointed a lot of people in life but I sure am not going to add bourbon to that list. So, here goes nothing....

Firstly, this post assumes that one already knows the importance of setting stop losses. If not, don't worry, the market will teach you soon enough! But seriously, don't trade without one. This post is not about the importance of stop losses but rather, about where to place stop loss points. With that out of the way, let's move on....

What's the point of this post? Well, dear readers, if you have traded the market actively in the last few years, you know that the obvious doesn't work anymore. Now, I am not saying technical analysis doesn't work anymore, just that it doesn't work as it used to. Things are not that simple anymore, specially with the advent of these computer algorithms. But we will save the broad topic of changes in technical analysis for some other rainy night, and stick to stop losses for this post. 

How many times have you readers seen yourself getting stepped out of a position only to see it change course without you? Seen it happening more than usual lately? Well, this was happening to me last year and I was forced to adapt. It sure hurts when you see yourself going on getting stopped out only to see the position run without you. But in order to make any changes to our trading system, we first have to figure out what's changed that's causing our stops to get run over so often. Read on....

Pick up your favorite technical analysis book, the one that you learned TA from. I am sure the author tells you to set your stops below the support points. The logic is that a break of these important pivot/support points indicates a change in trend. These support points are usually MA(50), MA(200), trendline support, gap support etc. And let me tell you my dear readers, these "support" points are exactly the reasons why you  lately might be finding yourself getting stopped out only to seeing the position run without you.

And here is the reason why. Actually, a couple of reasons. Firstly, the advent of computer algorithm trading. I forget and am too lazy to look up for the exact number, but over 70% of the trading volume these days is due to these computer algorithms. And when you set your stop losses at obvious points like just below the above-mentioned support levels, all you are doing is giving these computer algorithms an opportunity to get your stocks cheap. I am sure all you readers have noticed the sharp one minute or so spikes in the charts cutting below these support points. What you are seeing here is these computer algorithms just running through a lot of stops in a short instant. "They" know there will be a bunch of stop orders placed below these major "support" levels. The same happens with stops just below whole numbers. Why do you wanna give away your shares cheap?

The second reason is more to do with the nature of technical analysis itself. As more and more traders get familiar with technical analysis and follow these simple, obvious strategies like buying a bounce off MA(50) etc., the less and less these strategies are bound to succeed. Trading is all about having an edge, and as more and more people follow these strategies, the edge is lost. Just open the Apple daily chart for the last few months. Notice how many times MA(50) was broken on either side, like it didn't even exist. Remember, the markets like to follow the direction of maximum pain. Over 95% of the short term traders lose money. So, what makes you think you can make money by doing the obvious. Think about it! Again, technical analysis does work but changes have to be made to adapt to these times, but more on this some other day.

So, now we have seen that we should certainly not set our stops at obvious points. That's just giving money away. Give your stocks some more room to run. But more room to run equates to taking more risk. Now, probably the most important thing to consider before entering any position is the reward-to-risk ratio. Setting the stop loss point further away means one has to be more careful in entering positions and make sure that the entry point is as close to the stop point as possible. If that sounds like tough and hard work, it is!! Who told you trading was going to be easy? Actually, let me change that. Trading is easy, being successful at it is incredibly hard and a lot of work. 

One strategy could be to actually enter the position at this spike down meant to take the stops. I know it can be nerve wracking to enter on a spike down, but you will find that setting your stop just below the spike offers a very attractive reward-to-risk ratio. Remember, this spike should be on heavy volume as its there to collect all those obvious stops.

I like to set my stops based on the charts. I also like to enter positions based on how far my stop would be located though I admit, I am not always disciplined enough to follow this. This is a change I have to strive to make in my trading. The basic philosophy behind successful trading is to take care of the risk and the rewards will take care of themselves.

Some traders set their stop losses based on a fixed percentage loss. To each his own and I am not saying there is anything wrong with this style of keeping stop loss points, but I am not in favor of such strategy as in this case, one is setting a stop loss for the account rather than the individual position. The fixed percentage might not mean anything special in case of the individual stock. And if one is trading based on individual charts, it makes sense to set stop loss points according to the charts too.

So, these are my thoughts on setting stop loss points dear readers. The post turned out to be a lot longer than I had planned or expected and I hope it was of some use to you readers. Gotta give my undivided attention to bourbon now....Take care and good luck!