A bad place

Among the many misconceptions about stops one stands out as the worst. It has cost investors and traders billions of dollars and will, undoubtedly, cost them more. This misconception is that one should place stops on long positions immediately below the latest low.

This idea has been around for so long that it has acquired the look and feel of received truth. It became popular because it is so simple, feels comfortable, and does not require much thought. Even I took this advice early in my trading career and passed it on to others—until, as so often happens, reality hit me on the head.

There is one major problem with placing a stop immediately below the latest low—it very likely will lose money. The trouble with such stops is that markets very often trace out double bottoms, with the second bottom slightly lower than the first. I could fill a book with charts showing this pattern. The level immediately below the latest low is where amateurs cut and run and where professionals tend to buy.

Whenever prices approach a bottom area, I become very alert to the possibility that they could penetrate to a lower low. If prices fall to a new low, while the indicators fall to a more shallow low, creating a bullish divergence, I wait for prices to rally slightly. When they rise above the level of the first bottom, they flash a buy signal. I consider this one of the strongest and most reliable trading signals—a double bottom with a bullish divergence, with the second bottom slightly deeper than the first (see Figures 5.1 and 5.2).

It boggles the mind to think of the thousands of people who, year after year, put their stops slightly below the latest bottom. Why do people put their stops at precisely the level where they are most likely to be hit? Why do they sell at the level where the professionals are likely to be buying?

Crowds crave simplicity. Putting a stop a penny below the latest lowis so simple, anyone can do it. And the bulk of trading literature reinforces this pattern.

Figure 5.1 CPWR daily

Good trades tend to come together slowly, and this was certainly the case with CPWR. As it slid in July and August, it created multiple bullish divergences, culminating in the bullish divergence of MACD Lines in August. It reached the low of 7.46 at point A in August. Any trader who bought and put his stop “a penny below the latest low” got tossed out in September, when the stock briefly fell to 7.44 at point B. The question at the right edge is this: where will you put your stop if you buy here?
Professional traders exploit the crowd’s tendency to place stops a penny below the latest low year after year. They know where those stops are. There is no law that prohibits professionals from looking at charts. Some are even holding stop orders for their clients at those levels. The pros expect to find clusters of stops just beyond the edges of congestion zones.

As a stock sinks towards the level of an important low, its trading volume tends to dry up. All eyes are on that stock, but there is not a lot of activity, as people wait to see whether the support will hold. A small sell order, thrown at the market while buy orders are thin, can push the stock down, below its previous low. That’s the area where many serious pros love to operate.

As the falling stock sets off the stops of public customers, the pros snap up shares at a discount. If there are so many shares for sale that the stock accelerates down, they quickly cut their losses and let it slide, but this rarely happens.

Figure 5.2 CPWR, daily follow-up

The market often meanders while it gathers steam for a dash. CPWR briefly fell to 7.32 at point C, punishing those who casually place their stops immediately below the latest low. That is where beginners cut and run, while professionals tend to go shopping in those areas. Was that fishing expedition a crime? Probably not—just a pack of savvy pros trading against the unprepared and fearful amateurs.
Normally, the number of shares sold by the people with stops is not that great. As their sales get absorbed and the decline stalls, the pros jump in, joining the feeding frenzy, buying below the lows. The stock rises back into the range, leaving behind a brief downspike—a trace of the pros’ fishing expedition. They have just scared a bunch of anonymous amateurs into selling them goods at a discount. Has this ever happened to you?

Military officers know the value of veteran troops—they hold up under fire. Inexperienced troops are more likely to break and run, but veterans are not easily scared. Time and again they push inexperienced opponents from their positions. The beginners who survive might grow into tough veterans themselves. I hope that working through this book will help you accomplish this goal. And if I have convinced you not to put your stop “a penny below the latest low,” then I have not wasted my time writing it.

So—where should we put our stops? Review Figures 5.3 through 5.6.

Figure 5.3 S&P500 daily

In a sharp mini-crash in February 2007 the Standard & Poor’s 500 index fell out of its channel but then appeared to have found a bottom, with the Impulse system turning blue.

Figure 5.4 S&P500 daily follow-up

Sure enough, prices bounced up strongly enough to hit the upper channel. Unfortunately for many beginners, prices stabbed below the first low before flying off. Their expectation of a rally was correct, but tight stop placement would have led to a loss instead of a profit.

Putting a stop a penny below the latest low tends to be a losing proposition. What are the alternatives? Let us review several possible solutions.

Figure 5.5 TINY daily

A beginner may look at the double bottom in TINY and says: “Wow, look at these divergences! I’ll buy and put my stop one tick below the lowest low.”

Figure 5.6 TINY daily follow-up

TINY was an exciting stock in an exciting industry, with exciting technical patterns. It did build a base in early January and flew up about 25% before the end of February. Trouble is, it flew up only after it kicked out early buyers who put their stops a penny below the latest low. That low was 11.02, and the stops at 11.01 were taken out when the stock briefly fell to 11.

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