Over the years, I’ve come to think of successfully managing stops as the most crucial part of trading- and the most elusive.
There are virtually an unlimited number of ways to make entry decisions. What’s most important about selection methodology is that you choose one which you completely understand and which matches your temperament.
There are the various technical indicators (“buy when the 50 crosses the 200″, “short when the stochastics indicator crosses 80 from above”, “buy when the ADX is above 20 and the price retraces to the 20EMA”, etc). There are fundamental indicators (”their gross margins and revenue have been accelerating for 3 quarters now”). And of course, there’s the most popular indicator of all, “they say.”
MIA: Is that a fact?
VINCENT: No it’s not, it’s just what I heard.
MIA: Who told you this?
MIA: They talk a lot, don’t they?
Our success doesn’t depend so much on which method we use to enter positions (except for “they say”). It depends on what we do with those positions once entered.
Few positions are losers from the instant we enter until we exit– most are in the money at some point. The gains or losses we eventually take on them are due to our exit strategy.
To make matters worse, we usually don’t modify our exit techniques at all after a loss due to bad stop management (or none). We play the game of “woulda, coulda, shoulda,” bemoaning how this one “got away,” and set about looking for the next entry “opportunity.”
Let me take a moment here to mention various, often outrageously expensive software packages and “advisory newsletters.” These all exist in response to our collective addiction to ignoring the lessons our own trading teaches us, and instead searching more obsessively for the next great entry opportunity. Those entries are not what will make you money; they only create the potential. Where you exit determines your profit. I know that seems overly obvious, but it is a crucial lesson we often ignore.
How many times have you bragged about how much you could have made if you’d sold at such-and-such a price? Why didn’t you sell? Why did you hold hoping for more (and feeling smug)… then hold hoping to get back near the top (and feeling panicky)… then find yourself just hoping to break even (and feeling like someone just took a quart of your blood)?
That’s Trading 101. No, I take that back. It’s remedial trading.
Until we accept our fundamental nature as animals at the mercy of operant conditioning (and particularly variable reinforcement), we can never expect to succeed at anything that can fool us with occasional rewards. That’s why casinos thrive. We think we see patterns or can figure out strategies on something as mathematically rigid as a Roulette wheel, when all that’s happening is a reward here and there, no matter what our “strategy” is. How much more do these tendencies sabotage us in something as vast and opaque as the stock market!
When you’ve bought (or sold short) based on whatever method you choose, you must know your exit strategy in advance. You cannot expect to magically find the ability to override your natural propensities just at the right moment. That does not make you weak, or a failure. It makes you human. Welcome to the race.
Your long-term success in trading depends largely on your stop methods. If you spend your trading career ignoring the necessity of clear exit rules (whether due to pride, greed, emotion or ignorance), you will remain in a churning, chaotic world of lost opportunities, and will eventually bankrupt both your trading account and your self-esteem.
How do I set my stops?
This is truly a subject for an entirely separate article, because it’s just about as nebulous a question as “where should I buy.” I will try to summarize here by saying the stop should be geared to the particular trade: always consider your time frame (rule #1… or 3, I forget) and always consider the volatility of the particular stock (more volatile requires a wider stop).
I use various stop strategies, and they’re always evolving, because as I said at the beginning of this article, I think it’s the most crucial and elusive part of trading.
Right now, my favorite technique is a variation on the PSAR, where I trail my stop based on the difference between the previous stop level and the hi or lo of the most recent bar (that can be 5min bars for daytrading, or weekly bars for position trading). It ain’t the Holy Grail, but it does pretty well at keeping me in for a move, but taking me out before I bleed too much. Other times I’ll use a method as simple as setting the low of the prior bar (or prior 2 or 3 or 4 bars) as a stop. All depends on the “sitchiation”.
Cheers, and best of luck with your trading!