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.

Nic`s stop - tighter by a day

In a Traders’ Camp in 2003 I met a trader by the name of Nic Grove. His story, with its colorful personal details, is in some way typical of how people come to trading. As a young man growing up in Australia, Nic was involved in his family’s real estate business, then went out on his own as a commercial landscaper. By the time he turned 50, he grew tired of the routine, and sold his business. He flew to Paris, rented a small apartment, and started learning French. Looking for something to do and generate income, Nic stumbled into trading. He happened to read my book, came to a camp, and gradually we became good friends.

During the bull market in 2004 Nic and I were buying stocks that had been temporarily driven down to their EMAs. We wanted to hold them for a rally back to their upper channel line, using a fairly tight stop. Nic suggested looking for the low where most people would place their stops and then examine the bars that bracketed that low on each side. He would then place his stop a little below the lower of those two bars. This concept is easier to illustrate than to describe in words. Please see Figures 5.7 through 5.12.

Figure 5.7 CVS daily

CVS is in an uptrend on the weekly chart (not shown). This daily chart shows that it was pulled down into its value zone between the two EMAs. The lowest low of the decline was $30.46, bracketed by two higher lows, $30.76 and $30.66. If we go long CVS, Nic’s stop would belong slightly below the lower of those two bracketing lows. Since the lowest of them was $30.66, I would put a stop at $30.64 or even $30.59—on the other side of a round number.

Figure 5.8 CVS daily follow-up

CVS hung around its value zone for a few more days before it took off and hit the target at the upper channel line. The stop below the second lowest low was never endangered.

Figure 5.9 Gold daily

Gold, while in a bull market on the weekly chart (not shown), got hit by a piece of bad news and driven down. It fell below its lower channel line, a deeply oversold area. The lowest point of the decline was $635.20, bracketed by two lows: $642.20 and $642. I would place a stop slightly below the lower of the two, avoiding the round numbers—$641.90 or $641.40.

Figure 5.10 Gold daily follow-up

Gold rallied to $659.80, into its value zone between the two EMAs and appears to have stalled. The stop was not hit, but now would be a good time to take profits—since gold is at value and does not seem to be going up.

Figure 5.11 Gold—2nd follow-up

Gold punched its lower channel line for the second time. The second decline was less powerful than the first, leading to a bullish divergence of the Force Index. At the right edge, gold looks like an attractive buy again. The lowest low of this decline was $637.70, bracketed by the lows of $648.80 and $645.00. I would put “Nic’s stop” slightly below the lower of the bracketing lows, at $644.40.

Figure 5.12 Gold—3rd follow-up

This chart shows that the rally continues. The stop held well, protecting the trade.

This very tight method of placing stops is especially suited for short-term swing trading. Trying to catch a bottom tends to be a dangerous business. A very tight stop like this one does not allow any time for dreaming. It tells the market to put up or shut up.

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.

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.

Hard and soft stops.

A hard stop is an order you place in the market. A soft stop is the number you keep in your mind, prepared to act as soon as the market reaches that level. The distinction between them is extremely important, but I am a little reluctant to discuss soft stops here. It is a topic for professional and semi-professional traders, and I am concerned that some beginners may misunderstand and misuse it. For most beginners, a soft stop is like no stop at all.

This reminds me of a TV commercial I once saw—a company advertised a soft drink by showing people on small motorbikes zooming up and down steep slopes. Splattered across the bottom of the screen in big white letters was a warning: “All tricks performed by trained professionals. Kids: do not attempt to duplicate at home!” And that’s exactly what I’d like to say about soft stops.

If the topic is so dangerous, why not leave it out of the book altogether?

Because I want this book to be useful for the people who are rising to a higher level of trading who may find hard stops too rigid. I want to put control into your hands, trusting you to make reasonable decisions.


Just remember that hard stops are for everybody, but soft stops are permitted only for the pros or serious semi-pros.

Whatever method you use for setting stops, in the end you will come up with a number—the level at which your stop belongs for the next trading day. Will you make that number a hard or a soft stop?

A hard stop goes into the market as a specific order—you actually give it to your broker. The big plus of a hard stop is that it allows you to take your eyes off the market. It is perfect for those who cannot be in front of the screen during trading hours and who do not like making decisions in real-time. Beginners must use hard stops because they have neither the expertise nor the discipline to make decisions in real-time and carry them out.

Professional systematic traders use hard stops, but professional discretionary traders may use either hard or soft stops. A pro can do his research, come up with a number for a stop and enter it into his record-keeping system—but he may not necessarily give that order to his broker. He may watch that level, prepared to exit if prices get near it, but give himself a bit of latitude at the same time.

Using soft stops requires two things—iron discipline and full-time attention to the screen. You have no business using soft stops if you are not in front of the screen, ready to execute a trade when the market hits your level. You also need absolute discipline. A beginner who freezes in fear and keeps hoping for a lucky break when the market turns against him should not be using soft stops.

Soft stops can provide a terrific benefit by allowing more flexibility than hard stops. As the market starts heading down towards your stop level, you may decide that the stock looks heavy and get out earlier; you may cut losses sooner and save more money. Alternatively, you may decide that a decline on low volume could be a fakeout move and hold the stock a little longer, giving it a chance to recover. Needless to say, in all of these situations you need to know exactly where your stop is and exactly how you are deviating from it. An experienced professional can benefit from the flexibility of a soft stop, but too much freedom is deadly for beginners.

A trader has no right to use soft stops until he or she has traded profitably for one full year. Even then you may adopt soft stops only slowly and continue to use hard stops when you are away from the screen.

Since the decision-making process for establishing stop levels is the same for hard and soft stops, I will not be making any further distinction between them in this chapter. We will discuss how, where, and when to place your stops. You will need to decide whether those will be hard or soft, depending on your level of expertise.

Market or limit orders

All orders can be divided into two broad groups—market and limit orders. A market order is filled at what brokers like to call the best price—but what is in fact any price and often the worst price. An alternative to a market order is a limit order. It demands an execution at a specific price—or no execution at all. A limit order helps you avoid slippage.

A market order guarantees you an execution but not the price. A limit order guarantees you the price but not the execution. You must choose one or the other because you cannot have both in the same trade. You have to decide what is more important to you—an execution or an avoidance of slippage? You may answer this question differently at different times, depending on what you are trying to accomplish.

Suppose you’ve bought 1,000 shares of a $19 stock, and your research indicates that if it declines to $17.80, the uptrend will be over. You call your broker or log into his website and place a stop order to sell 1,000 shares at $17.80, good until cancelled. Normally, a stop order is placed below the market as an MIT order—“market if touched.” If you put your stop at $17.80, it will become a market order to sell 1,000 shares the moment that stock trades at $17.80. Your position is now protected. You can go about your life and feel less worried about that stock.

A market order is a slippery thing. In a quiet market, you may get filled at $17.80. Occasionally, you may get very lucky, and if prices bounce after touching $17.80, you may get filled at $17.81 or $17.82. What is much more likely to happen, however, is that during a sharp downdraft the stock does not linger long enough at $17.80. You put your MIT stop at $17.80, but when you get your fill, it is at $17.75. This slippage on 1,000 shares has just cost you $50—probably several times larger than your commission.

Prices move smoothly only in quiet markets but they can jump across several price levels when the action heats up. Putting an MIT order at $17.80 does not guarantee you’ll be filled there. In a fast decline you may suffer slippage and get filled at $17.78, $17.75, or even lower. If a sudden piece of very bad news hits your stock, it may gap all the way down to $16, or even lower.

A stop is not a perfect tool for protecting your profits or reducing losses—but it is the best tool we have. Stung by slippage, some traders switch to limit orders. They order to sell only at a specified price, using a limit order for their stop. I strongly disagree with this tactic.

I almost always use limit orders for entering trades and taking profits at target levels. A limit order says, in effect, “my way or the highway.” I will only do business at a level that suits me, and will not accept slippage on an entry or on profit-taking. If I miss entering a trade as a result of a limit order, I do not complain—there will be many other trades in the future. If you try to enter a trade using a limit price and do not get filled, you lose nothing.

The situation with protective stops is completely different. If you miss an exit from a trade, you can get caught in a waterfall decline. A trader can lose a lot while fiddling with limit orders, trying to save a few pennies. When the trouble hits, run without haggling. That is why I use limit orders for entries and profit-taking but switch to MIT orders when using stops.

Selling on a stop: The iron triangle

The main purpose of using a stop is to protect yourself from an adverse move by limiting the loss on a trade to a predetermined amount. The secondary purpose is to protect paper profits. With loss control being the key purpose of stops, it is no wonder that setting stops is tightly linked with money management.

The process of risk control works in three steps:

1. Set a stop on the basis of chart analysis and calculate the dollar risk per share by measuring the distance from the planned entry price to the stop level.
2. Use your money management rules to calculate the maximum amount you may risk on a trade in your account and decide how much you will risk.
3. Divide the number of dollars in line 2 by the number of dollars in line 1 to find out how many shares you may trade. I call this sequence the Iron Triangle of risk control. One side is your risk per share, another your total permitted risk per trade. The third side, derived from the first two, gives you the maximum trade size.

Stop placement is tightly linked with trade sizing. Once you decide what to trade, you need to decide how big a position you will put on. Most people make this decision on the basis of some vague gut feel. They trade bigger after a few successful trades or smaller after getting slapped around by the market. Many approach the sizing decision from the wrong angle. Some trade the same number of shares every time, others invest the same percentage of their account in every trade. These common approaches make little logical sense.

Size, as the joke goes, does not matter. What matters is risk.

As a trader, you do not really trade IBM or EBAY or soybeans—you trade money and you deal in risk. This is why you must set your position size on the basis of risk. It is risk, rather than any external factors like number of shares or the cost of a position, that matters.

Compare buying 1,000 shares of a $20 stock and placing your stop at $17 to buying 2,000 shares of a $40 stock and placing your stop at $39. Even though the size and the cost of the second position is greater, the amount of risk is lower.

Let us review the three steps outlined above, followed by a few trading examples:

1. Calculate dollar risk per share. Suppose you decide to buy a stock that is trading at $18. Now suppose that your chart analysis indicates that if this stock falls below $17 it will cancel the bullish scenario. You decide to place a protective stop at $16.89. Your risk per share then will be $1.11. It could become even higher in the case of slippage, but $1.11 is a reasonable estimate.

2. Calculate dollar risk per trade. Suppose you have $50,000 in your trading account and follow the 2% money management rule, as explained in Chapter 1. This means that your maximum risk per trade is $1,000. That is actually quite a lot of risk for a modest account. Many traders decide to risk less than 1%.

3. Divide your risk per trade by risk per share. This is how you find the maximum number of shares you may trade. If your maximum permitted risk per trade is $1,000 and the risk per share in the planned trade is $1.11, your maximum number of shares is below 900. Remember, the $1,000 maximum allowed risk per trade must cover commissions and slippage. Also, there is no law that says you must go up to the maximum permitted risk on every trade. You are not allowed to risk more, but you are perfectly welcome to risk less.

What if you have big expectations for that $18 stock? You may want to give it some extra room and place a stop as far away as $15.89, but then your risk per share would be $2.11. Since the maximum permitted risk for the trade would remain the same, your maximum purchase would drop to 470 shares.

On the other hand, if you sit in front of the screen, watching that stock like a hawk, you may put a stop at $17.54, and risk only 46 cents per share. Your maximum permitted risk will remain $1,000, but now you will be able to trade a 2,170-share block.

Decisions about stops are tightly linked to decisions regarding profit targets. You must weigh the amount of risk you are willing to take against the potential reward you are trying to reap. As a rule of thumb, I am attracted to trades with reward-to-risk ratio of 3:1 or better. I would be very reluctant to enter a trade whose reward-to-risk ratio is 2:1 or lower.

Using stops is an essential practice. Before we discuss the wide variety of stops available to you, let us clarify two extremely important distinctions. We must choose whether to use market or limit orders for our stops. We also need to look into the rarely discussed choice between soft and hard stops.

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.

Selling at resistance levels

Moving averages can provide targets for rallies from deeply oversold levels. Channels or envelopes can provide targets for short-term traders. These tools help catch short-term swings—but such moves seem puny to long-term position traders. We used to call such people investors, before the whole world accelerated and everyone became a trader of one sort or another. Long-term traders, whose time horizon is measured in months or even years, need bigger targets. A deer hunter needs a bigger gun and a different scope than someone who goes out shooting rabbits.

Support and resistance zones provide better targets for long-term trades. We can identify support and resistance by looking for price levels where a great deal of trading has taken place, clearly more than the areas immediately above or below.

In order to have confidence in any technical tool we must understand how it works and what it measures. To put our money on the line, we need to go deeper than merely drawing lines on charts. If we are going to rely on support and resistance, we need to understand the economic or psychological factors they represent.

Each price tick reflects an agreement between a buyer and a seller, but it also represents something greater—the opinion of the crowd that surrounds these two people. Had the crowd disagreed with either the buyer or the seller, someone would have stepped in and snapped away that trade at a different price level.

The more transactions that occur at a certain price level, the more people believe that level represents value. A congestion zone on a chart tells you that many market participants consider that level a fair value and are prepared to buy or sell there.

If you look at any chart, you’ll notice that prices very seldom move in a steady and orderly way for any great length of time. They almost never move in a straight line. Instead, prices stay within a range, swirling behind an obstacle like water behind an earthen dam. Once the dam breaks, the stream of prices surges until it finds another basin. It will now spend a long time filling that basin, until it breaks a new dam and surges again.

If each tick represents a transaction between a buyer and a seller, then a trading range represents a general consensus of value between masses of buyers and sellers. When prices lap at the edges of a range, amateurs become excited. They expect breakouts and buy new highs or sell new lows. Professionals know full well that most breakouts are false and are followed by retracements. They tend to trade in the opposite direction, selling at the upper edges of congestion zones and buying at their lower edges. Once in a blue moon the amateurs win, but in the long run it pays to trade with the pros.

This back-and-forth action of prices draws trading ranges on many charts. A range is a horizontal pattern with fairly clear upper and lower boundaries which identify support and resistance. A price range represents a huge financial and emotional commitment by masses of buyers and sellers. If you glance at the average daily volume inside the range, multiply it by the number of days in that range and then by the average price of the stock during that time, you will immediately realize that a trading range for a single stock can quickly run into billions of dollars.

Support and Resistance

When traders and investors buy and sell, they make an emotional as well as a financial commitment. Their emotions can propel market trends or send them into reversals. The longer a market trades at a certain level, the more people buy and sell. Suppose a stock falls from 80 and trades near 70 for several weeks, until many believe that it has found support and reached its bottom. What happens if heavy selling comes in and shoves that stock down to 60? Smart longs will run fast, banging out at 69 or 68. Others will sit through the entire painful decline. If losers haven’t given up near 60 and are still alive when the market trades back towards 70, their pain will prompt them to jump at a chance to “get out even.” Their selling is likely to cap a rally, at least temporarily. Their painful memories are the reason why the areas that served as support on the way down become resistance on the way up, and vice versa. Regret is another psychological force behind support and resistance. If a stock trades at 80 for a while and then rallies to 95, those who did not buy it near 80 feel as if they missed the train. If that stock sinks back near 80, traders who regret a missed opportunity will return to buy in force. Support and resistance can remain active for months or even years because investors have long memories. When prices return to their old levels, some jump at the opportunity to add to their positions while others see a chance to get out. Whenever you work with a chart, draw support and resistance lines across recent tops and bottoms. Expect a trend to slow down in those areas, and use them to enter positions or take profits. Keep in mind that support and resistance are flexible—they are like a ranch wire fence rather than a glass wall. A glass wall is rigid and shatters when broken, but a herd of bulls can push against a wire fence, shove their muzzles through it, and it will lean but stand. Markets have many false breakouts below support and above resistance, with prices returning into their range after a brief violation. A false upside breakout occurs when the market rises above resistance and sucks in buyers before reversing and falling. A false downside breakout occurs when prices fall below support, attracting more bears just before a rally. False breakouts provide professionals with some of their best trading opportunities. From Trading for a Living by Dr. Alexander Elder, John Wiley & Sons, Inc.,1993

Have you ever noticed that people tend to become a little emotional about money?

Do you think that a crowd with a billion dollars’ worth of commitments might be inclined to act when those commitments are threatened?

Support and resistance are built on two powerful emotions—pain and regret. People who have bought in the range only to see prices drop feel a lot of pain. They are waiting for prices to return so they can “get out even.” Their selling, driven by pain, is likely to put a lid on any advance. People who sold short in the range are also waiting for a pullback. They regret that they did not short even more. Their regret will lead them to sell short when prices return to the level where they shorted, resisting the advance. Pain and regret will put a damper on a rally into a trading range or a decline into that range.

Let us review examples of support and resistance on the charts of some well-known markets: IBM and the Euro.

In 2005 IBM (see Figure 4.21) fell into the $73–$78 zone, spent about three months there, and then erupted into a rally. Half a billion shares were traded in that zone, with an approximate value of $37 billion.

Figure 4.21 IBM, weekly chart

A. Half a billion shares traded at approximately $75—about 37 billion dollars within this range. B. Notice how downspikes of Force Index tend to identify important market bottoms. Can you find two more downspikes on this chart?

You can begin to imagine how much emotion was attached to that huge pool of money! When IBM fell back into that zone a year later, there were enough buyers who regretted that they had missed the boat earlier. They soaked up the supply and pushed IBM back up, up, and away.

How can we set good targets for massive rallies? Looking into IBM’s history on the same chart you can see that in recent years whenever the stock got into the $95–$100 zone, heavy selling drove it down. Think of those poor folks who bought near $100 in 2004. After sweating and suffering through the bear trend, don’t you think they were waiting for IBM to rise back to their purchase price, so that they could “get out even?”

Yet of course, “even” is never really even. Think of the lost interest, the depreciation of money, and the loss of opportunity because the money was tied up in IBM at $100 a share. Think of the psychological burden of sitting on a losing position and not being able to concentrate on better opportunities. The losers are waiting, ready to dump millions of shares when the stock finally returns to their purchase price. If you were one of the smart traders who bought near $75, wouldn’t you expect the rally to stall near the $100 level? That zone of overhead resistance would have been a very sweet level for placing your profit target.

The Euro (Figure 4.22) erupted from the gate soon after its listing in 2001, rising from 85 cents to $1.36 within three years. A severe bearish divergence in 2005, marked by a red arrow on the chart, capped the uptrend and sent prices lower. The Euro found support near the 2004 lows, then dipped below that level, frightening the bulls.

It is important to keep in mind that support and resistance are not made of plate glass. They are more like wire fences, and bulls and bears can push parts of their anatomy through them. As a matter of fact, some of the best buy signals occur after the bears manage to push prices slightly below support. This sets off stops and takes out the weak holders before the bulls resume control and lift prices again. We already discussed the signals from false breakouts in an earlier chapter.

At the right edge of Figure 4.22 we see a bullish divergence. The last bar on the right edge has turned blue. This change of the Impulse system tells us that the bears are slipping and buying is now permitted.

If we go long here, what will be the target for the upmove? It would be rational to expect resistance in the congestion zone of the 2005 top, between 1.3 and 1.35.

Figure 4.22 The Euro, weekly chart

A. Support. C. A bullish divergence. B. A bearish divergence. D. Resistance.

Currencies are notoriously hard to trade since they move nearly 24 hours a day. You may be peacefully asleep in your bed while your competitors halfway across the globe are picking your pockets. You wake up to discover that the price move you’ve expected to see has already occurred. If you are a swing trader, looking to catch price moves that last a few days to a few weeks, you are better off staying away from currencies. Leave them to day-traders and to long-term position traders. These people can benefit from the currencies’ well-established tendency to run in long trends.

To follow up on the chart of the Euro, in Figure 4.23 we see a combination of signals—a bullish divergence of MACD, a false downside breakout, the Impulse system turning blue on the weekly chart. They confirmed each other in area B and generated an especially strong message to buy. The entry into this long trade in the Euro worked out extremely well. The buy signal allowed us to set a reasonable long-term profit target—at the resistance in the trading range of the 2005 top.

After the Euro hit resistance at point C it stalled and went flat for several months. At the same time, the behavior of MACD-Histogram in area C indicated that prices were likely to rise higher. The new MACD-H

Figure 4.23 The Euro, weekly chart, follow-up

A–B. Bullish divergence. C–D. Bearish divergence.

peak C, the highest in over a year, showed that bulls were at a record strength. This meant that the price level associated with this indicator peak was likely to be exceeded.

That’s exactly what happened near the end of 2006 and again in early 2007, but on those occasions MACD-Histogram was giving different messages. Its bearish divergences signaled that the upmoves were nearing their ends.

Looking at support and resistance helps you set reasonable targets for long-term moves. The great value of such long-term targets is that they help you fix your eyes on a remote but reachable goal. This helps you hang on to a long-term move and not get thrown off your horse by the short-term action of prices or indicators or both.

Another benefit of having a long-term target is that it reminds you to sell in a predetermined zone. If you buy low, it would be useful to have a reminder to help you sell high. Many traders become more bullish near the tops, along with the rest of the market crowd. A target tells you when your goal has been reached. It may not be a perfect goal, but it is your target. You have set it, and now it tells you to take profits, go home, take a nice vacation, and look for the next trade.

Psychologically, it is much harder to trade long-term trends than short-term swings. In short-term trading you are active, watching the market every day, ready to adjust your stops and profit targets, add to your position, take partial profits, or exit the trade altogether. Many of us find this feeling of control psychologically satisfying. The emotions tend to be very different in long-term trading. There are weeks and even months when you do nothing. You recognize short-term tops and bottoms but restrain yourself from doing anything, as you wait for your long-term target to be hit. That’s why having a price target is so important—it increases your psychological holding power.

To conclude this chapter on setting profit targets at support and resistance, I will share with you another trade from my diary (see Figure 4.24). It will illustrate techniques, as well as some psychological points. It will show why it is harder to hold a long-term position than a short-term trade. And it will allow us to discuss several important issues relating to the management of a trade, beyond simply setting a profit target.

Figure 4.24 STTSY monthly

My attention was drawn to STTS, since renamed STTSY, during a monthly webinar in November 2004. One of our most active participants at the time was Jackie Patterson, a Californian who had left her job to become a full-time trader. She was a good stock-picker, but no stock she brought up had gotten me as excited as STTSY. This computer-chip testing company traded above $60 in the happy days of the 1990s bull market but fell below $6 during the bear market. It was one of those “fallen angels” we have already discussed. The idea, of course, is to buy after a stock stops declining. It is OK to buy cheap but not OK to buy on the way down. The weekly chart appeared extremely attractive. It showed that after the stock crashed from above $60 to below $6, it bounced above $17. Another fall, below $5, was followed by a bounce to nearly $16. This puppy’s behavior made it clear that even after it lost over 90% of its value it had no desire to die. A stock that has survived a bear market becomes a prime buying candidate for the next bull market.

Figure 4.25 STTSY weekly

At the right edge of the chart STTSY fell again, below $6. The price level below $6 emerged as a very strong support zone. In looking at the chart, it became evident that the zone near $16 provided very strong resistance. Whenever STTSY rose to that level, it seemed to hit a ceiling and come tumbling back down to the floor.

Zooming into the right edge of the weekly chart (Figure 4.25), the picture became even more attractive. The stock established three lows during the past six months at $5.50, $5.40, and $5.37. This pattern told me several things. First of all, the support was solid. Even when the stock was pushed to a slightly lower low, it refused to accelerate to the downside, but instead recoiled and came back up. Furthermore, the fact that STTSY kept stabbing to lower lows looked tremendously bullish to me. Those quick stabs seemed to indicate that some powerful interests were trying to push the stock a little lower in order to frighten holders into selling so they could buy up their shares. David Weis, a very experienced trader, jokingly called such interpretations “a paranoid view of the markets.”

The bears were so weak that MACD-Histogram stayed above zero during the latest decline. Force Index, in the bottom pane of the chart, showed three stabs to the downside—each more shallow than the

When the Impulse system went blue at the right edge of the chart, it removed the last prohibition against buying. I bought 10,000 shares at $5.99. My plan was to hold until STTSY reached $16, which I figured might take a couple of years. I was looking to clear a $100,000 profit on this trade.

As the stock began to move in my favor, I added another 5,000 shares at $6.13, but a few weeks later offloaded that lot at $6.75, clearing 62 cents and booking a quick profit on that side bet. My plan was to hold for the long haul, but this turned out to be much more stressful than quickly trading in and out.

STTSY briskly rallied to $8.16, then sold off back to my buying point. I was convinced that my initial plan was correct and continued to hold. STTSY rallied again, this time to $8.85. I saw multiple signals of a top, including a bearish divergence of weekly Force Index, marked with a red arrow on the chart (Figure 4.26). Focusing on my target of $16, I clenched my teeth and held. The decline quickly wiped out nearly $30,000 of paper profit and the position briefly went negative as STTSY dipped below my entry point. I held on to my original plan, focusing on the bullish details, such as a “kangaroo tail”—a one-bar stab towards the lows. It was accompanied by a bullish divergence of Force Index, marked with a green arrow on the chart.

Figure 4.26 STTSY weekly

STTSY rallied again, this time up to $8.42, but holding long-term was becoming less and less fun.

During this trade I made a multitude of shorter-term swing trades in other stocks. Trading short-term was a lot more fun and profitable. I also held a handful of other long-term positions, similar to STTSY, as my plan was to teach myself to hold for the long haul. Still, my position in STTSY was starting to feel like a headache. I’d had enough of those rallies into the $8–$9 zone, followed by declines back down to the purchase point, with no profit to show for my work or patience.

In February 2007, two years after I bought STTSY, the stock rallied to $8.65, slightly better than its previous high of $8.42. There the rally stalled and the weekly ranges became narrow. Such signs often precede price declines. I felt the weight of STTSY on my shoulders and gave an order to sell, getting out of my 10,000 shares at $8.39. Instead of hitting my $100,000 target, I cleared less than $24,000 on this trade— $27,000, taking into account a side bet on STTSY early in the game. I was happy to be out of STTSY, liberated from having to look at the stock as it gyrated up and down. Still, I had gotten into such a habit of watching it that I kept an eye on it (see Figure 4.27). What I saw turned out to be highly amusing, to say the least.

Figure 4.27 STTSY weekly, follow-up

Just a few days after I got relief from selling STTSY, the stock stood on its hind legs and roared. Two weeks later it traded near $12. Most indicators confirmed the great strength of the bulls by reaching new record highs. They signaled that whatever brief weakness may intervene, the bulls were very strong and that $12 was likely not the final peak in STTSY. The stock appeared ready to go higher, and the initial target of $16 looked very realistic.

Did I buy it back? Of course not! My two-year entanglement with STTSY was over. The relatively small profit I took out of its ongoing spectacular move would be the only money I’d make out of it—much less than what was available. So why show this trade here? Is there anything we can learn from it? Yes, quite a lot. Here are the lessons, in no particular order:

1. As we said earlier, whenever you put on a trade, you have two goals: to make money and to become a better trader. You may or may not reach the first goal, but you must reach the second. If you do not learn from your trades, you are wasting your time and money. During this trade, I kept good notes, both in a spreadsheet and in a visual format in my diary, allowing me to extract lessons from the experience. The money profit was relatively small, but the trading lessons were multiple and rich.

2. First of all, my entry into this trade was excellent. I had correctly identified an important bottom and acted in good time. Second, my profit target for the trade appears to have been on track even though I could not hold long enough to get full benefit from my analysis.

3. This trade confirmed to me that I am temperamentally better suited for shorter-term trading. Since I am determined to learn to hold long-term, I must adapt by adding some elements of short-term trading to my long-term positions. I decided that in future long-term trades I will establish a core position that I will hold from start to finish—its smaller size will produce less stress. At the same time, I will put on larger short-term trades in the direction of my long-term trade. Looking back on Figure 4.26, there would have been every reason to buy extra on the way up, sell when tops were formed at the upper dashed line, and buy again whenever the stock fell back to its original buy zone near the lower dashed line.

4. This trade reminds us that it is important to treat yourself well. Your mind is a trading instrument, and abusing yourself for mistakes, such as getting out too early, would be like slapping your computer—it does not improve performance. My goal is to learn from my mistakes, not to punish myself for them.

5. Last but not least, I want you to see that even experts make mistakes. I still make them. You will continue to make them. The idea is to weed out gross mistakes, such as not using a diary or violating money management rules. Once you’ve done that, you can concentrate on the lesser ones.

As I write this book, I have several long-term trades going. There is a major U.S. industrial concern whose stock, I believe, wants to rise from $7 into the $20+ range. I am even more excited about a little Nasdaq number that trades for a bit over a dollar. It traded near $100 in the 1990s—this fallen angel lost over 99% of its value in recent years. I acquired the bulk of my position below $1 and expect to hold it until the stock reaches $20 a couple of years from now. With both stocks, I have a core position that I do not touch and a bigger short-term position that I keep putting on and taking off, actively trading in the direction of the trend. The lessons of STTSY are continuing to help me.

A Rally Stumbles

What if you set a profit target for your trade at the envelope but later come to believe that the rally has even greater potential? How much longer can you hold? Experience has taught me that it is better not to overstay trades. Still, occasionally situations occur in which a rally rockets higher, and it feels tempting to hold on for a bit more than initially planned.

Once prices blow through your initial target, where will you take profits? There is an option that appeals to me because it feels the least stressful. I wait for the first day when the price fails to reach a new high for this move and sell either near the day’s close or soon after the opening the following day.

Here, as with everything else in trading, it is important not to try to reach for extremes. The top tick of a rally is the most expensive tick in the market—fortunes have been lost hunting for it. The logic behind the “no-new-high” tactic for a fallback target is straightforward. When a super-powerful move cannot reach a new high, it gives you a sign that the bulls are starting to run out of breath.

Figure 4.20 YHOO, daily chart

Of course, they may regain their breath and reach even higher, but I have long ago given up on trying to catch the absolute top. Remember, the top tick is the most expensive tick of every rally.

Figure 4.20 shows a YHOO rally that began in October. At first, it moved like so many other trades—below value in October, followed by a rally to the upper channel line, then a drop back to value in October, followed by another rally to the channel. Following the second rally, prices barely declined, showing that the bulls were very firm and not giving way to the bears.

After prices touched their value zone in November, they staged an explosive move to the upper channel line. They reached the line within one day and rocketed higher the following day. On the third day of this rally, the bulls appeared to either have lost confidence or taken a rest. The range on the third day was narrow and the volume thin, reflected by falling Force Index. Even more important, the bulls failed to lift prices to a new high for this rally. That was the signal to sell.

Prices did rally a little higher on subsequent days, but the bulk of the upmove was over. Three days after the “no-new-high” day, prices began to sink back towards value. Selling early beats selling late. Only someone with a crystal ball can call the top of every move, but those who live by a crystal ball must get used to swallowing a lot of ground glass. It is important to trade without regrets about missed opportunities. Remember—the power word is “enough.”

Holding Out for More

When it comes to dealing with the good things in life, the majority of people always want more—a bigger house, a shinier car, perhaps even a newer and better spouse. I remember being stopped dead in my tracks at a party where I talked to a couple; the husband had just received an important promotion and the wife spoke of wanting to “upgrade our friendships.” The entire advertising industry pushes us to reach for ever more. No wonder so many people spend their lifetimes in a mindless race, like caged animals chasing their tails. This endless race tends to become very dehumanizing.

When people who have bought into the rat race come to the market they also tend to reach for more, more, more. Even a profitable trade brings them no joy; it burns them to see that they neither bought at the low, nor sold at the high, but left some money on the table. This bitterness drives them to either buy too early or sell too late. People who keep reaching for more usually gain a lot less than those who follow their tested methods.

Those who reach out for more than the market is willing to give often end up with much less.

The power word in life, as well as in trading, is “enough.” You have to decide what will make you happy and set your goals accordingly. The pursuit of your own goals will make you feel in control. To always crave more is to be a slave to greed and advertising. To decide what is enough is to be free.

Do not get me wrong—I am not suggesting you take a vow of poverty. I like flying business class, living in a nice place, and driving a powerful convertible as much as any other guy. What I am saying to you is this: find the level at which you will be satisfied and be happy when you get there. This is so much better than always feeling off-balance, short, chasing after an ill-defined “more.”

And what to do if “more” somehow falls into your lap? What if one month you hit the market just right, and super-profits drop into your account? The experience of super-profits unhinges most people. Craving even more, they climb farther out on a limb and take wild risks the following month until their super-profits turn into super-losses. In order to stay cool and calm you need a personal plan for managing profits—we will return to this topic in the chapter on the personal dividend.

For a trader who craves more and more, the idea of taking profits near the upper channel line can feel very stressful. Some trades do not reach their target while others overshoot it.

You cannot become fixated on the channel as an iron-clad profit target. If the market starts acting weak, there is nothing wrong with accepting less than your initial target. Neither trade shown above quite reached the upper channel line. EXTR missed it by a bit, gold by a wide margin—but both ended up being very profitable. Paradoxically, being willing to accept less often gives you more. See a recent trading example in Figures 4.16 and 4.17.

An even greater source of stress for greedy traders comes from powerful moves that overshoot their targets and keep on going. A trader looks at a market from which he exited with a nice profit and starts kicking himself as that market continues to move in the same direction—only now without him.

Let us review another trading example. In January 2007 I became very bullish on sugar, on the basis of weekly charts (not shown). I began building a long position in the March 2007 contract, eventually taking profits and rolling over into May (see Figures 4.18 and 4.19).

Figure 4.16 Wheat, daily chart

A. Bullish patterns on weekly and daily charts—go long.
B. Took profits on 1/3 of the position, held the rest.


This chart of wheat shows a very nice purchase near the lows, following multiple bullish divergences. Prices accelerated and punched above the upper channel line. I was so bullish on wheat at the time (based on the weekly charts—not shown) that I took only partial profits. I violated my rule and did not sell above the upper channel line.

Figure 4.17 Wheat, daily chart, follow-up


Wheat continued to reward greed for two more days after my partial exit.
Prices kept hovering above the upper channel line but then collapsed. I had to scramble as my open profits melted away. The entire profit for this wheat trade would have been much greater had I gratefully accepted what the market was giving me, instead of reaching for more.

I am sure that we could find many examples of prices rising above the upper channel line and continuing “to walk the line,” rising with the line. Of course it happens, but that is not the point. My point is that “enough” is better than “more.” It leaves you feeling calm and in control—and these feelings lead to greater profitability in the long run.

This brief discussion raises one other important point. Not all my trades are successful—some lose money while others, such as the ones shown above, earn much less than what was available.

Figure 4.18 Sugar, daily chart


Sugar prices jumped soon after the rollover. The chart above shows that the entire day’s bar popped above the upper channel line. In the face of such great strength I took only partial profits on my longs, but held the remaining two-thirds of my position. I was so impressed with sugar’s strength—which confirmed my bullish forecast—that I ignored the fact that the bar above the upper channel closed near its low—a suspicious sign of weakness.

Figure 4.19 Sugar, daily chart, follow-up


The following day, sugar prices collapsed and I had to scramble. My total profit on this trade would have been much higher had I sold the entire position on a break above the upper channel line. I missed a great opportunity by taking only a partial profit.

When I recognize that I have made a mistake, I do not beat myself over the head. I create a diary entry, analyze what happened, and learn as much as I can from my failings. I accept my imperfections, and as long as I learned something from a trade, that trade was a good, productive experience.

Selling at envelopes or channels

We have seen how moving averages on the weekly and daily charts present good profit targets for the rallies that jump off the bear market lows. Later, after a bullish trend has established itself, you will rarely— if ever—see such targets. As prices keep chugging higher, moving averages start lagging behind them. This is why moving averages do not make good targets during steady uptrends.

Before we continue our search, let us take a look at an important pattern on this weekly chart (see Figure 4.9). It shows one of the most powerful signals in technical analysis—a bearish divergence between prices and weekly MACD-Histogram.

Figure 4.9 INFY, weekly chart

This weekly chart of INFY shows a rally to value early in 2006; that’s when a weekly moving average would have worked as a target. It was followed by a powerful upmove during which prices stayed above value for months. Clearly, a moving average would not have provided a target under these conditions. We need to find a better tool for targeting exits during uptrends.

Following peak A, MACD-H declined below zero—I call this “breaking the back of the bull.” The stock rallied to a new bull market high at point B, but the indicator traced out a much lower, almost non-existent peak. That was a loud warning to the bulls. This signal was confirmed by a multitude of other bearish signs: a breakout of prices to a new high with no follow-through; a bearish divergence of Force Index; and completely flat MACD-Lines.

Figure 4.10 INFY, daily chart

While the weekly chart of INFY shows prices running above their moving average for months, this daily chart of the same stock during the same time period shows a very different pattern. Prices keep running higher within their price channel, as if on invisible rails. Such orderly patterns are fairly typical in steady uptrends. A stock keeps moving up, fluctuating between value (its moving average) and the overvalued level at its upper channel line.

When a stock is rallying in this fashion, the space between the two EMAs, the value zone, is a good place to buy. The upper channel line shows where that stock becomes overbought and marks a good zone for profit-taking.

We can see the shorter-term action on the daily chart, shown in Figure 4.10. Trading a stock in such an uptrend—repeatedly buying at value and selling at the upper channel line—may feel like going to a cash machine (although I’m reluctant to use the phrase because nothing in the markets is as simple as going to an ATM). Still, you can see a steady repetitive pattern, as the stock oscillates between its value zone, which keeps rising, and the overvalued zone, which keeps rising as well. This pattern gives traders a good profit target—selling at the upper channel line.

If moving averages help define value, then channels or envelopes drawn parallel to those averages help define overbought and oversold zones. Ideally, we want to buy below value, below the moving averages, and sell at an overvalued level, near the upper channel line. We will grade our performance by the percentage of the channel we can capture in our trade, keeping in mind that anything above 30% will be considered an A trade.

During one of my monthly webinars, a trader named Jeff Parker brought CEGE to my attention (see Figure 4.11). I run these webinars once a month, and each consists of two sessions a week apart.

Figure 4.11 CEGE, weekly compressed

A couple of dozen traders gather in a virtual classroom to review the markets and specific stocks. Many participants bring up their picks for me to review. If I like a pick very much, I announce that I will probably trade it the next day. That was the case with CEGE, which immediately attracted my attention.

Compressing the weekly chart of CEGE into a single screen, you can see that the stock had rallied above $60 in the happy days of the 1990s bull market. It then crashed and burned, tried to rally a few times, but sank below $3 near the right edge of the chart. By then it had lost over 95% of its peak bull market value. I call stocks that have fallen more than 90% “fallen angels” and often look for buy candidates among them. My entry into CEGE is shown in Figures 4.12, and 4.13.

Figure 4.12 CEGE, weekly chart

Opening up the weekly chart, you can see a powerful combination—a false downside breakout accompanied by a bullish divergence of MACD-Histogram. The Impulse system has turned blue at the right edge, allowing buying. The latest bullish divergence was of a “missing right shoulder” type, meaning the indicator could not even decline below zero. It showed that bulls were growing strong, as bears were running out of breath.

Figure 4.13 CEGE, daily chart, entry

The daily chart showed that the first rally from the oversold lows had already taken place. Prices were in the value zone on the daily chart. The upper channel line on the daily chart presented an attractive target for the next leg of the rally. At the same time, there was a good possibility that prices could overshoot this target, in view of a very bullish pattern of the weekly chart.

When the webinar resumed the following week, we revisited CEGE. Jeff, whose pick it was, spoke about it being very overbought. Prices had shot up towards the upper channel line, without quite reaching it, and stalled for two days. MACD-Histogram reached an overbought level. Since I had a number of long positions at the time, I decided to prune my holdings by selling CEGE shortly after it opened the following day (Figure 4.14).

My exit grade was only 6%, as the stock rallied sharply after I sold. It was a poor grade, but one cannot score highly on every single sale— the important thing is to try to keep the average grade above 50%. My trade grade, however was an A—I took 36% out of this stock’s channel.

A few days after I exited, Jeff called, kicking himself for having sold too soon (see Figure 4.15). I tried to humor him—look, by having sold early we freed ourselves from the stress of having to decide what to do with the super-profits of a runaway trend! Seriously, though, this trade provided several important lessons.

Figure 4.14 CEGE, daily chart, exit

Figure 4.15 CEGE, daily chart, follow-up

The follow-up of this trade is a mixture of comedy and pain. The stock exploded after I sold, and I heard from several webinar participants who sold a day or two after me and scored much greater profits. And then it exploded again. And again.

First of all, it is important to have confidence in your profit targets and not sell too soon. Second, it does not pay to kick yourself over a missed opportunity. This will only lead to reckless trading down the road. I told Jeff that he had to congratulate himself for having picked such a good stock. If you keep buying good stocks, eventually some of them will bring you windfall profits.

In Figure 4.15, notice how much wider the channels are on the follow-up chart than on the one preceding it. I use a program called Autoenvelope which automatically draws channels that contain approximately 95% of the recent price data. When prices jump, an Auto-envelope becomes wider. This is a reminder that in trading we never shoot at a stationary target—the target always moves, making the game harder. Here I took profits near the channel wall—but a few days later the “wall” moved!

CEGE returned to narrow daily ranges after its brief price explosion. It began to sink back towards the base where we had bought, working its way towards becoming an attractive buy once again.