Stop Order Placement

From Our September 2014 E-mail Archives: One of our traders had some frustration with getting stopped out too soon on trades, so he asked our Head Trader, Robb, for some advice.*


-----Original Message-----

From: Chris T.
Subject: Stop Order Placement

Good evening,

Hi Robb,

I have a really quick question for you. I just started my 200 trades in the Maverick Simulator. I've done my first 15 and I'm up $500 or so, but there was one thing I'm not sure if I'm doing right. I've had instances where I thought I saw a beautiful bull pullback and got the confirmation...only to get stopped out at the top of a big red candle.

My question is, "Should I put my stop a little more than 1 ATR (Average True Range) from a) where I bought or b) where the stock closed for the day?

On the surface, I would think from where I bought it since capital preservation is as important as gains, but it doesn't leave the stock much room to move and I'm more likely to get stopped out quickly. I had one that was bearish (had just broken through all the moving averages) and sell volume was high, so I shorted it. Then, it gapped up $50 in 3 days!

Thanks again for the advice.

Regards,

Chris


-----Reply Message-----

Hi Chris,

Thanks for the email. Your question is a great one that is really at the heart of trading.

First of all, I personally hate stops since the thing that annoys me most is to be stopped out on a good trade due to short term price volatility. One of the reasons I love options is that I can basically put built-in stops (max loss), but hold through all that volatility. However, on the Maverick Trading Simulator and in some styles of trading, stops are the only choice that you have. In those cases, putting stops in the right place really is an art form.

The biggest thing to remember about stops is that they are there to protect you from the catastrophic losses (15%, 20%, 50%, etc.), but many people put their stops so tight that they are protecting a 0.5% loss. So, stop placement really needs to start with the big picture of "At what price will I be convinced that my trade is totally wrong (broken trends, support lines or moving averages)?" Then, you can move into the chart and start to put some numbers to it.

ATR is a good place to start, but 1 ATR is really tight. Statistically, 1 ATR gets stopped out about 55% of the time in the first 5 days. One of the things that we talked about at our 2014 Chicago Summit was using an options pricing calculator to help calculate stop losses. Start with what % of the time you are OK with being stopped out in the first 5 days.

For example, if a trader said that he wanted his stop outs to happen no more than 30% in the first 5 days, then all that he would have to do is put the stock into a statistical calculator (thinkorswim, OptionsOracle, optionsXpress, etc.) and see where the statistical probability of 30% falls in the first 5 days. Let's say there is a stock at $50 and the calculator says that in the next 5 days, there is a 30% chance that the stock will trade below $47. That would be the stop price for that trader and he would position size for that level of loss.

While there are several different ways to determine stop placement, the most important thing is for the stop to be far enough from the current price of the stock to not get triggered due to normal volatility (which is 1 ATR each day), but not be so far away that you give up needless $$$’s when you know the trade is broken. Many of our traders use things like the 50-day simple moving average (SMA), the most recent pivot point/support, or Fibonacci lines to determine stops. In the end, exactly where you put your stop isn't the most critical thing – as long as you aren't too far or too close.

For a simple example, let's say that you put a stop at 5% and I put mine at 7%. Sometimes, your stop will be correct (e.g., if the stock drops 10%, then I will lose 2% more than you). However, sometimes the stock will pull back 5.1% and rebound. In that price action, you will be stopped out at your 5% max loss and I will still be in the trade. At the end of 1000+ trades, there shouldn't be a huge difference as the extra 2% I gave up on the bad ones will likely be made back by me on the ones I am able to stay in and you aren't. What really matters is consistency over that 1000+ trades.

I know that I haven't given anything really specific, but I hope that this helps you determine the best place for your stops. I personally like the 50-day SMA as a really simple, loose stop point. However, with good charting skills, you can likely determine better stop points above that SMA.

Hope this helps,
Robb

* NOTE: Some original wording has been modified for legibility.