Selling on a stop

If you compare buying a stock to getting married, using a stop is like signing a prenuptial agreement. If your happy relationship hits the rocks, the prenup will not take away the pain, but it will reduce the hassle, the uncertainty, and the expense of the separation. What if you are a happy bull but discover that your beloved stock has been sneaking out and getting between the sheets with a bear? Any breakup is going to hurt, but the best time to decide who gets what is when you still tenderly hold each other’s hands. Price targets help you hold on to the stocks that move in your favor. Stops help you sell when the stocks turn against you. Even a profitable trade deserves to have a protective stop. Some traders also like to ride runaway trends by using trailing stops that follow rapidly moving prices. A stop provides an essential reality check for any trade. Yes, you love this stock. Yes, you have great expectations. But what if it doesn’t work? Have all your previous stock ideas worked out well? Or has there been one or two that did not? More than one or two? Many? Is there any doubt then that you need a stop? You need to examine the chart and decide where you want to get out if that trade starts going against you.

Once you put on a trade, a pernicious “ownership effect” will set in, making it much harder to decide when to sell. The best time to make that decision is before you enter a trade.

Think of that old-fashioned jacket that hangs in your closet. You cannot bring yourself to throw it away—because it is yours, you are used to having it, you’ve always had it. At least that useless jacket does not cost you anything beyond taking up space in your closet. (And in your mind, I might add—holding a useless possession creates a tiny dead spot—and after a while many little dead spots merge into bigger dead zones). At least you won’t have to pay rent for the jacket that hangs there. On the other hand, having a dead trade in your account can become very expensive. It can become downright ruinous.

A single bad trade, if large enough, can punch a hole in your account. A group of bad trades can destroy it.

Another side effect of not using stops and holding on to bad trades is that they interfere with making good trades. Just as a toothache interferes with your thinking and prevents you from planning new and exciting things, a losing trade grabs more of your attention than it deserves.

It prevents you from seeking out new and better trades. Whenever a trade that’s gone against you has your nerves tied in a knot, it makes it harder for you to get into a new trade. Even when it looks promising, you find excuses not to buy. Holding on to a losing trade costs you money, pain, and missed opportunities.

A trading system without stops is not a system—it is a joke. Trading such a system is like racing a car without seatbelts. You may win several races, but the trouble is that the very first crash could end your career.

If you are a discretionary trader, stops are your link to reality. You may have beautiful ideas of profits, but deciding where to put a stop forces you to look at the possible downside. It makes you ask the essential question: Is the potential profit worth the risk?

Every trade deserves a protective stop. Follow this simple rule: you may not put on a trade unless you know exactly where you will place your stop. You must make that decision before you enter a trade. In addition to the stop you need a profit target to evaluate that trade’s reward-to-risk ratio. A trade without a target is like a chip tossed on the green felt of a casino table.

About 20 years ago one of my friends hit a rough patch in his market career and went to work as a broker. I moved one of my accounts to him, and whenever I called to place an order, he would not let me get off the phone until I also gave him a stop. My friend has since grown into a successful money manager, but I remember him as the most disciplined broker I ever had.

And what about moving stops? Markets change, prices change, and your outlook on a stock may change. You may become more bullish, more bearish, or less certain. As your perception of risk and reward changes, you may want to move your stop. How can you do it? In a market where everything is permitted—most of all losing money— what rules will you set for moving stops?

The absolutely essential rule of moving stops is that you may move them only one way—in the direction of the trade. When you go long and place a stop below the market, you may move it up but never down. When you go short and place a stop above the market, you may move it down but never up.

You buy a stock because you expect it to go up. If it starts going down, it tells you that your decision was poor. Had you expected that stock to go down, you would not have bought it. Moving your stop farther away to accommodate your mistake would only compound the error. Don’t do it. Using stops is a one-way street. You may tighten them but never loosen them.

Let us summarize what we have discussed so far:

• You need stops; a trade without a stop is a gamble.

• You need to know where you’ll put your stop before you enter a trade (if the reward-to-risk ratio is poor, do not enter that trade).

• Everybody needs hard stops; only expert discretionary traders are allowed to use soft stops, discussed below.

• Whenever you change a stop, you may move it only in the direction of the trade.
If you have any doubts about these points, please go back and reread this chapter. If you agree, let us move forward and discuss how to place stops. As they say in real estate, “there are three key factors in this business: location, location, location.”

An important footnote about stops—it is perfectly fine to re-enter a market after it hits your stop. Beginners often make a single stab at a stock and leave it alone after it kicks them out. Professionals, on the other hand, see nothing wrong with trying to buy or sell short a stock again and again, like trying to grab a slippery fish, until they finally get it by the gills.

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