Reducing slippage - tighter by a penny

Most traders do not use stops. The fact that you are thinking about them and reading this book is a positive sign. Stops improve your chances of rising above the crowd.

Looking at most charts, you can make a fairly good guess about where careless traders would place their stops. When crowd members use stops, they tend to place them at very obvious levels. They slap them immediately below support when long or immediately above resistance when short. Since the crowds lose on balance in the financial markets, it pays to do things differently from the majority. Here and in the next few chapters we will discuss several alternatives to those obvious levels.

If you make your stops tighter, you’ll reduce your dollar risk per share, but you’ll also increase the risk of a whipsaw. If you place your stops farther away, you will reduce your risk of a whipsaw, but your losses per share will become heavier when your stops get hit. Both approaches have their pluses and minuses, but you must choose only one for any given trade. Like so many choices in the markets, your decision will depend more on your attitude than on any objective study of the market.

My approach to using stops has formed gradually, much of it the result of painful experiences. When I first began to trade I did not use stops. After several beatings from the market I learned that I needed stops for protection. I began using them, but placed them in an amateurish way—a tick below the latest low on long positions or a tick above the latest high when going short. Needless to say, I kept getting stopped out by whipsaws.

To add insult to injury, I noticed that when I placed my stops the usual way, one tick1 below the latest low, it exposed me to a great deal of slippage. A stock would decline to the level where my stop had been set, but when I received my confirmation, the fill would be several ticks lower. My broker explained that there were so many stops at my level that when the stock hit it, it just went flying. With all those sell orders, including my own, flooding the market, the buyers were momentarily overwhelmed.

What could I do about it? The pain of losing provided plenty of motivation. I decided to tighten my stops and began placing them not one tick below the latest low, but at the actual low level. Looking at many charts, I saw that there had been very few instances when a stock declined exactly to its previous low and held there, without going a tick lower. Normally, it either held well above that low or went well below it. This meant that placing a stop one tick below the low did not add to my safety margin. So I began placing my stop at the actual low, instead of going one tick lower.

This method largely eliminated slippage on my stops. Time after time, a stock would come down to its previous low and just boil there. There would be a great deal of activity but not much movement. Then the stock would fall a tick below its old low and hit an air pocket—whoosh!— falling several ticks within moments.

I realized that the level of the previous low was where the pros re-jigged their positions. The action was tight, and there was very little slippage there. Once the stock fell a tick below its previous low, it was in public stops territory, and the slippage became hot and heavy. With that discovery, I stopped placing my stops a tick below the recent low. I began placing them at the exact level of the previous low—and my slippage on stops drastically diminished. I used that method for many years—until I switched to an even tighter method of placing stops.