A Professional Perspective on Protective Stops

A good Stop-Loss Plan is like an insurance policy designed to protect against catastrophic loss and the premiums are just the cost of that protection.
Safe and responsible behavior can greatly reduce the cost of that coverage.

The best professional stop-loss advice ever: Avoid trades that can easily results in a loss. Patiently wait for the market to offer up a low-risk, high-reward opportunity in the direction of the broader market trend; and when the broader market trend turns against your position or is highly likely to turn against your position, get out and patiently wait for the next favorable opportunity. An alternative to always getting out with a loss, is to have a strategy (a plan) to convert a foreseeable loss into an acceptable profit or to at least minimize that loss.

Stop haphazardly trading random market noise. Only an Idiot would expect positive results from random odds. Once you've factored in commissions, slippage, more random market noise, and the fact that the guy on the other side of your trade is likely to be a professional trader or a computer programmed by a team of professionals, the odds are high that your random trade will result in a loss. Don't be a Trading Idiot reacting to evolving market stimulus — a Trading Idiot is an unprepared, undisciplined trader who wants the benefits of being a professional but is unwilling to do the work required to become a professional trader. Notice: If your trading tactics are causing your brokerage account to progressively lose value, you just might be a Trading Idiot; let this Notice be your Protective Stop.

A true professional trades with a consistent statistical edge and thinks in terms of probabilities (refer to Mark Douglas' book Trading in the Zone for more information or listen to his lecture on the subject). Events that have probabilistic outcomes, like the market and games of chance, can produce consistent results when you can get the odds in your favor and there is a large enough sample size. This is how the casinos and true professional traders alike generate amazing annual returns. The primary factors affecting this probabilistic outcome are the professional's ability to Have a Trading Plan with a Real Edge and the Discipline to Work that Plan!

Start with a simple strategy (a trading plan) that puts the odds of success in your favor. This plan should contain a set of rules to control the process and generate consistency, which should eliminate haphazard randomness. A reproducible process facilitates analysis and quantifiable adjustments. When you first start out, do your analysis and planning when the market is closed. When the market is open, mechanically trade your plan with small share sizes. Be rigid in your rules and flexible in your expectation. In your plan, have a set of rules that specify what actions are to be taken given an objective set of market criteria that is appropriate for the trading timeframe — if your timeframe is less than a week, your entry and exit criteria should be based primarily on chart data; however, any holding timeframes longer than that should also consider the fundaments of the investment. The stop-loss exit should be based on a violation of one of the strategy's basic assumptions (e.g., we're in an uptrend and should not see a lower-low or the economy is growing and that is bullish for a diversified basket of Blue-Chip stocks). The entry should be close to the stop-loss exit, thus allowing you to cut your losses short. The target needs to be both likely and far enough away from the entry to justify the risk of a loss, the insurance premium.

The following simple (example) Bullish Up Trend Trading Plan is based on the idealized chart pattern to the right:

Part 1:
The market is in an uptrend (putting in a pattern of higher-highs and higher-lows) in the trading timeframe and the next longer timeframe and is now pulling back into near-term support off a prior pivot high or a rising moving average. If the market bounces off this support level, I'll enter long with 200 shares (the working default size, more on this below). Once in, I'll place my stop-loss 3 cents below the entry pivot bar (this amount should be based on recent volatility). I'll look to sell half the position in a rally to the prior pivot high, and the second half in a bounce off a new high pivot, which should be about twice the distance of the current pull-back from the prior pivot high and the current pivot low. Once the position gets halfway to the first target, I'll raise my stop-loss to my entry price. If I'm able to sell the 1st half, I'll raise my stop on the second half to 10 cents below the sale bar (just below the prior high level). If the market fails to break through the prior pivot high and starts to retrace, I'll just sell the first half at the market to lock in a small gain to reduce trading costs and hold the 2nd half to either my original stop (or if I raised it to my entry, there) or my original new pivot high target.

Part 2:
Patiently wait for the market to offer up the strategy's entry condition. Once given a likely setup, analyze the broader market environment to validate the current risk-to-reward situation (more on this below). If the odds still favor the trade, put on (enter) a properly structured trade (details to follow), and then let the trade run (as planned) to either outcome — the likely profit target/condition or the alternative stop-loss exit.

This simple trading plan, the Bearish alternative, and all the variations on this theme are relatively easy to master in longer timeframes and have favorable odds in just about every timeframe. But please understand that in shorter timeframes, the harder it becomes to see the pattern, thanks to market noise, and the harder it becomes to trade successfully, thanks to narrower trading ranges and the fact that the competition will be some of best traders in the world.

The hallmark of a true professional is not the size and frequency of their winning trades. It the size and frequency of their losing trades. A true professional is able to control the size and relative frequency of their losses thanks to Proper Trade Selection and Good Money Management.

Proper trade selection is all about waiting for favorable setups in the direction of the broader market trend. A favorable setup is comprised of two factors. The first has a good risk-to-reward ratio, where risk is defined as the dollar difference between your entry price and the stop-loss exit price and where reward is defined as the dollar difference between your entry price and your target exit price. These position entry and exit prices are defined by the support and resistance (pivot trend) pattern on the chart of the current (trading) time frame and also on the next one or two longer time frames. The other factor is based on the likelihood of being able to hold your position to the target and honoring your stop, which are both psychological issues that you can learn to master by repeatedly employing proper trade planning and disciplined plan execution. Fools trade without a rational stop; and it's just a question of time before the market forces the fool to lose any money put at risk. Amateurs use stops; but are often quick to enter a trade and are therefore quick to get stopped out. Professionals only takes trades that are not likely to be stopped-out because they know to wait for a Quality Set Up and use stop-out techniques that are more likely to keep them in the trade (e.g., enter with half the size and twice the stop or enter after the all-to-often Shake Out move).

Money Management is all about controlling your risk exposure. There are a number of important things you can do to control your risk exposure (e.g., only take trades with favorable risk to reward ratios and employing appropriate Risk Units & Position Sizing techniques). Even the best trading opportunities fail from time to time, and sometimes quickly and dramatically. A "Stop-Loss" plan is one of the best tools a trader can carry in his or her trading toolbox. Some have called stop-loss, "A line in the sand." Others have called it, "An insurance premium paid to avoid a catastrophic loss." Basically, it is the maximum amount of dollar loss you are willing to take on a failed trade. It can also be the maximum amount of time you are willing to wait for a trade to yield an acceptable profit. The best time to create a stop-loss plan is before entering your trade, while you are most likely to make decisions that are unburdened by emotional distress.

This stop-loss plan can be programmed into your trading system via a hard stop order or it can be soft via a manually entering the stop order by a disciplined trader according to the plan. Both (hard and soft) options have their advantages and disadvantages. The advantage of a hard stop is that it will be executed when the condition occurs; but it can also quickly kick you out of your position only to see prices move as initially expected, in a shack-out move that often occurs right before the primary move. The advantage of a soft stop is that you are less likely to be shaken out; but it requires you to monitor the trade and to have the self-disciple to execute the plan, which is hard for many to do. Bottom line, if you cannot do a soft stop as planned, use a hard stop.

The Stop-Loss Dichotomy: The golden rule of trading is "Let your profits run and cut your losses short!" But what is short? The tighter your stop-loss, the more likely it is to be hit; and a trader's account can die a death by a thousand cuts. On the other hand, a wide stop-loss is much less likely to be hit, but it cuts much deeper when hit. The primary consideration (tight, wide, or some place in between) must be based on the risk to reward ratio of the trade and the likelihood of the trade yielding the desired result; and this of course varies from trade-to-trade and trader-to-trader. Ultimately it comes down to the averages - your Measures of Success; or put another way, it is based on your Batting Average (BA) and Win/Loss (W/L) Ratio, another dichotomy - it is easy to increase your BA at the expense of your W/L Ratio and visa-verse. The proper selection should become clear in time as your trading experience grows; and is a price to be paid by every trader as they learn what does and does not work for them in the current market. As for me, I've found that it is best to have very tight stops in the first 10 to 15 minutes of the trading day because this is when stocks are most likely to break away quickly and dramatically; and when these trade turn against you, you want the bite to be small. Later in the day, I've found that it is generally best to have a little wider stops in trades that are in-synch with the broader market trend and tight stops on any counter-trend trades. But in all cases, never let the market take more than 1R, which is the professional approach to the initial stop.

The Initial Stop is the price level, the total dollar amount, the percentage drawdown, pattern violation, and/or the time selected before the trade is taken, that if reached, requires the trader to abandon the trade or position. The initial stop is all about cutting your losses short (i.e., before any one loss can do real damage to your trading account)! There are a number of strategies that can be employed in the selection of the initial stop. The basic idea is to select a point or condition that if reached, clearly says the current trade is not working out as planned and it is now time to give it up and move on. An example of price level stop is to select an initial stop-loss prices that is 1 to 2 cents below the current bar or the prior bar, whichever is lower when trading to the long side; if shorting, place it a penny or two above the current bar or the prior bar, whichever is higher. Another popular choice is to place it a few pennies below the current support level or above the current resistance level. These tight stops may get you shaken out; but if the trade still looks good, you can always get back in on the next setup. An example of the total amount is 1 Risk Unit, which is the maximum amount that you are willing to lose on any trade. An example of a percentage drawdown is 7%, which requires the trade or position to be closed when 7% of the position's value is lost. An example of pattern violation is a long position trade in a bullish power trend — an up (bullish) trend is defined as a pattern of higher pivot highs and higher pivot lows, if the position fails to make a higher pivot high, the uptrend becomes questionable and requires the trader to lighten up the position (i.e., reduce size), and if the position then fails to make a higher pivot low, the uptrend has been (by definition) violated and the trader is required to exit (stop-out). An example of a time stop is the 4:00 PM market close (i.e., this trade has until the close of business to work out). Your plan should include one or more of these initial stop strategies.

Please note that once in a trade, there is only one way a stop can be moved - in the direction of the trade. That is, you are only allowed to reduce the size of your loss. For example, if long, a stop can only be move up; and if short, a stop can only be move down. To do otherwise is an amateur move that will ultimately lead to failure. Sure, there will be times when violating this rule will result in a winning trade. But sooner or later, this bad habit will cause real damage. Traders who are able to see the plays and are able to support a high Batting Average (lots of winners); but are unable to grow the size of their equity over time are most likely violating their stop-loss plan or they are not doing effective stop-loss planning.

Trailing Stops are used once the trade moves into profitability. The trailing stop is all about letting your winners run! This is how a professional allows the market to compensate a good trader for cutting loses short; and is critical to overcoming the cost paid to professionally abandon losing trades. A professional trading plan includes a provision for the use of trailing stops (e.g., if the current time frame is in a power trend), which allows him or her to earn a high Win/Loss Ratio. There are three popular trailing stop methods:

1. Bar-by-Bar: As the trade moves into profitability by two normal (average) range bars, start to move the stop towards the profit target. The basic idea is that we'll give the trade one average range bar of play or wiggle room. For example, if we're going long and we get a 2-bar lift into profitability (two bars have competed and we're now in the third bar), we'll move our stop to just under the bottom of the prior bar (under the second bar); and when the third bar completes and we're now painting the fourth bar, we move our stop under the third bar, and so on. If the prior or current bar becomes a wide range bar, place the stop at the 45% point of that bar or so to retain the one average range bar of wiggle room (i.e., if we get a 55% retracement of the wide range bar, we'll take our stop). The advantage of this approach is that it allows you to let your profit run; but it also has the disadvantage of be whipped out of the trade much easier.

2. Riding a Moving Average: There are times when a stock will rally (when going long) nicely above a moving average (e.g., "Riding the 8 Train" - a rising 8-period MA) or below a declining moving average (when shorting). This moving average has an amazing ability to provide intraday support or resistance to an advancing issue. The advantage is that you are likely to harvest much more of the move; but unfortunately, not all advancement will ride a moving average - they're just too whippy. When a bar violates the MA, use that low (if long) or high (if short) of that bar as the new stop-loss point (i.e., we need a two-bar violation of the MA to stop out). If the violating bar is a wide range bar, exit A.S.A.P. (i.e., it becomes clear that this is not a normal range bar).

3. Pivot-by-pivot: A pivot is a V-bottom or top in the current chart pattern - it is a minor trend reversal. As the current trend moves in its normal two steps forward, one step back (a retracement), and then forward again pattern, this pivot-by-pivot approach has you use a violation of the prior pivot as your stop-loss. The advantage of this approach is that it is much less likely to be whipped out prematurely, and thus more likely to yield a much greater reward when the target issue is in a healthy trend. A healthy uptrend has a pattern of higher-highs and higher lows or higher pivots; and a healthy downtrend has a pattern of lower-highs and lower-lows or lower pivots. The downside, it will cost you a lot more when the stop finally does take you out of the trade. Once an above average profit has been earned or when we see a number of wide range bars, we can always revert back to a bar-by-bar or tighter MA stop.

The downside of all trailing stop-losses is that it will cost some of the unrealized profits in the end and could even result in bigger loss due to a fast, gapping trend reversal. A professional approach is to have a plan that takes a little profit along the way — lock in some of gains at intermediate targets/conditions and let the rest run. Note that any shares thus harvested can be added back in on a subsequent favorable setup (i.e., scaling in and out along the way). For example, we can take off a third of the position in a bar-by-bar violation, another third on an MA violation, and the last third on the pivot violation; and we can use a bounce-off an MA to add back a third. If the stock makes a big move and reaches or exceeds the best planned target and is now likely to retrace or reverse, why not just hit the cash register "Ka-Ching!" Once the tailing stop-loss has done most, if not all of, its planned job, why not lock in a high Win/Loss Ratio and call it a Good Trade?

This paper applies mostly to traders; but even investors (long-term traders) need stops and that stop should be based on one or both of the following two principles: 1) the fundamental reason for entering the investment is no longer true, and/or 2) the current phase of the business cycle is entering (or has entered) contraction (recession), which is very likely to cause all investments to lose value. Click here to learn more about the relationship between the economy and the broader markets trend.

Stan Benson