12.18.2008

When to use wider stops

The planned duration of your trade helps determine how far from the entry to place your stop. As a rule, a shorter time horizon calls for tighter stops, while a longer timeframe tends to require wider stops.

All timeframes have their advantages and disadvantages. One of the key benefits of longer-term trades is that they give you the time to think and make decisions. At the other end of the spectrum, if you are day-trading and stop to think, you’re dead. Every advantage in the financial markets comes at a price. Longer-term trading gives you more time to think and make decisions, but the cost of this luxury is the greater distance from your entry price to a stop. A stock can meander much more in three months than it can in three hours. As traders we shoot at a moving target; given more time, the targets will move a great deal more.

A beginning trader is better off staying away from day-trading. This extremely fast game tends to quickly destroy amateurs. Nor would I recommend long-term trend-trading for those who are just starting out. The best way to learn is by making many small trades, keeping a diary, and practicing your entries and exits. Long-term trades do not provide the necessary level of activity to gain that experience.

Swing trading is a good place to start learning to trade. Once you have a year under your belt during which your equity curve shows an uptrend with shallow drawdowns, you’ll know that you are becoming good. Then you can decide whether to continue to focus on swing trading or to expand your horizons. If at that point you decide to learn long-term trading, you will need wider stops.

Why wider stops?

To avoid whipsaws. The only logical place for a stop is the level where you do not expect prices to go.

Think about it—if you go long and place a stop below the market, you want to have it at a level where you do not expect prices to decline. You would not want it where a whipsaw becomes a real possibility. You want your stop at a level that could be reached only if the trend reverses.

If you identify an uptrend and go long, your stop belongs at a level that is safe from the normal chop of prices. A major uptrend is naturally swingier than a little price move. If the noise level is greater, the stops have to be wider.


Figure 5.13 KO monthly

When trying to put on a very long-term trade (what used to be called an investment in years past), it pays to begin by analyzing a monthly chart. This chart of KO (Coca-Cola) shows 20 years’ worth of history. You can see a bull market that took the stock from under $4 (split-adjusted) to nearly $90 in 1998, followed by a bear market slide to below $40. The area below $40 emerged as strong support which has stopped four declines since 2001. At the right edge of the chart the monthly Impulse system has turned from red to blue, permitting buying.

The principle of Triple Screen is to make a strategic decision on a longer-term chart (Figure 5.13) and execute on a shorter-term chart (Figure 5.14). With the monthly chart permitting us to buy we turn to the weekly chart to decide on our tactics.

Suppose you’re trading a $100,000 account and following the 2% Rule. If you place your stop at the closer of the two levels we just discussed, your maximum trade size could be nearly 600 shares. If you chose the wider stop, your maximum permitted trade size would drop to below 300 shares.

Of course every trader must make his own decisions, but I can offer you my take on the situation: a stop on a long-term position must be wide, but not so wide as to kill the trade size. I would be inclined to place my stop at the closer of the two levels—and be prepared to reposition

Figure 5.14 KO weekly

As usual, the trend of the shorter timeframe changes ahead of the longer term trend. The upside reversal is already well under way on the weekly chart. A bullish divergence of Force Index helps identify a bottom, and prices have already risen above their EMAs. This chart supports our buying decision. Prices are close enough to value to buy here. To set a price target, I prefer to turn to the longer-term chart. A level of about $60, approximately half-way back up to the top, would seem like a reasonable estimate. But what about a stop?

The latest low was $38.30 and the lowest low next to it (“Nic’s Stop”) $38.75. If you put your stop at that level, you will risk a bit more than $3 per share. Would that be a reasonable stop?

What if KO fell to its previous low of $37.01 and even violated it by a dollar before reversing to the upside? That would make the bullish picture even stronger but would require a stop of almost $7. if stopped out. Remember that professional traders will often take several stabs at a trade. Now let’s take a look at what happened to KO going forward (see Figure 5.15).

In summary, wider stops are a feature of long-term trades. If this approach attracts you, the key point to keep in mind is that as the width of your stops increases, the size of your trade must decrease, making sure you stay within the iron triangle of good money management.

Figure 5.15 KO weekly follow-up

Talk about patience! Had you bought KO at the level we discussed, you would have had to wait nearly a year before the uptrend got going. Prices did sink below the entry level but never violated their stop, even the tighter one. At the right edge of the chart prices have just broken out above their 2004 high. Several indicators are tracing bearish divergences. Shall we hold to our initial target of near $60 or take profits here? This is the sort of dilemma that burdens the lives of long-term traders.

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Naresh said...
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