How to Place More Effective Stops
I’ve received a number of questions lately about how to place stops, so I thought I would revisit this topic.
Having been on both sides of the aisle - the trader side and the brokerage side - I’ve got a different perspective on the issue of stop placement.
During my time on the brokerage side, I saw what goes on in the opaque world of trade execution, and, almost every day, I talk to traders who initiate the trades that trigger those executions.
“I can’t believe it, they hit my stop and then ran the stock right back up,” is a familiar complaint.
No doubt, this is one of the most frustrating things that can happen to a trader, but here’s the deal.
Of course they hit your stop, they knew right where it was.
But they’re not supposed to be able to see your stops right? And if they can’t see them, then how can they go after them?
More on that in a minute.
First, let me take a moment to clarify who “they” are.
To tell the truth, I don’t know who “they” are, but I watch their actions every day.
They could be market makers, specialists, bots, HFT’s, Algo auto-traders, a combination of all of them, or just the ghost of Paul Lynde.
It doesn’t really matter what the mechanics are, it’s just the results of those mechanics that matter.
The bottom line is that many entities in the market benefit from volume and “they” will do anything they can to create that volume, like triggering your stops with only a quote, instead of an actual trade.
This type of market action has changed the rules of trading, and let’s face it, the rules of trading have always been pretty dicey to start with.
If you had a 50/50 chance of a certain trading rule holding up in past markets, it’s now more like 20/80.
Of course, I’m just pulling those numbers out of my ass, but you get the point; the market has changed, and you have to change the way you trade it, especially when it comes to placing stops.
Let’s start with an illustration that I painstakingly created in a very high-end program called Microsoft Paint.
In days of yore, the way this trade would have played out is that you would have waited until a double bottom was put in at point B, entered on the bounce, and put a stop in below the red line.
If your trade failed and you got stopped out, the stock price would normally continue on down to new lows. But that’s not how it works these days.
More often than not, before the trend completely reverses and moves back up, you get one last shiv, as price quickly drops below the double bottom to point C, and then just as quickly reverses back up above the support line and continues to run higher.
This is when I hear traders start to holler about their stops being hit, run, liquidated, or “spanked” depending on what they’re into.
So can they actually see your stops and go after them?
No, they can’t, not in the sense you think they can.
In the past, if an individual, trading in size, wanted to try to run the stops, they didn’t have to be a genius to know where everybody and their brother put theirs.
Just by looking at a chart, and understanding human nature, they could figure it out.
In today’s markets, “they” know the same thing, it’s just that the “they” are computers.
So, no, they are not running your 100, 500, or even 1000 shares of XYZ, they are running the 10’s of thousands of shares of XYZ that they know are sitting just below the double bottom of the day.
If you are buying a breakout, it’s basically the same concept in reverse.
Price runs up, pulls back, bases, and proceeds to break to new highs, but then pulls back to point C and the wehewqlkg etoetdg=reegr.g.gge;wp %$$%()SSQds…
Sorry, my cortex just snapped from repeating myself for the millionth time. I don’t need to belabor this point, you get what I’m talking about here.
So the big question is; how can I place more effective stops?
There are basically three ways to do it, for each of which I will make up a random and important sounding name.
The Stop Plus
This involves adjusting your position size based on where your stop is, plus a little extra.
Normally, by knowing the spread between your entry and your stop, you can determine your position size.
But based on the new market dynamics you need to pad that spread, which will make your position size smaller, which gives you a better chance to avoid getting shaken out on a run to point C on “Chart A” above.
What you use for a “plus” factor depends on what type of asset class you are trading, the specific traits of the instrument in that class, and the overall market tenor.
One suggestion would be to start experimenting with a percentage of the daily average true range (ATR) and then adjust it depending on the results you get.
The Support Minus
Here you would actually anticipate the run of the stop area at point C on “Chart A” above and put a limit buy order there.
Basically, you are not buying support anymore, you are buying “support minus.”
What your “minus” amount is, once again, depends on some experimentation, but as a variation, you could break your position into two or three limit buys in a range below support.
The advantage of this method is that if you do get filled below support and the stock does not rally back over that level, you can be reasonably sure that support has truly failed and that the stock will continue lower, making your stop out a no-brainer.
The Hybrid
The last method is a hybrid of the previous two for those that worry they will miss a move if they try to buy below support.
I mean, what if the stock never hits your target and you don’t get filled?
OH, THE HUMANITY!
So instead, you take a half position on the bounce off of point B on “Chart A” above.
If the stock continues to run, so be it, but if it makes a stab past support to point C, you have some dry powder to grab the second half of the position.
This ultimately gives you a better average price, and once again allows you more room for the stock to bounce without stopping you out, though not as much room as the “Support Minus” method.
Conclusion
It’s common to refer to trading as “chess not checkers,” but these days it’s more like that 3D chess game from Star Trek, with a helping of Dungeons & Dragons and some poker thrown in.
Don’t try to think about it logically or fixate on the way things “should be.” Instead, just accept how things are, and use that knowledge to your advantage.
It should go without saying - but I’ll say it anyway - all opinions expressed in The Lund Loop are my own personal opinions and don’t reflect the views of my employer, any associated entities, or other organizations I’m associated with.
Nothing written, expressed, or implied here should be looked at as investment advice or an admonition to buy, sell, or trade any security or financial instrument. As always, do your own diligence.
