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GuidetoPlacingGoodStops

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GuidetoPlacingGoodStops

  1. 1.   2 THE ADAM MESH STOCK-COACHING PROGRAM The Guide to Placing Good Stops, A.K.A. “What Could’ve Been!” The hardest part of trading stocks is knowing when to sell. For starters, you must begin by accepting that you will never be perfect. In an ideal world that was geared toward keeping the average trader sane, you can just sell your stock and have it stop moving. That way you would never have to deal with “what could’ve been.” Chances are, when you sell a stock you will either be thinking that you should’ve held as it has already gone higher or you should have sold it earlier. That’s just the way we are programmed. The sooner you can accept that you will never make the “perfect trade,” the sooner you can focus on making big money. I often ask my students, what would bother them more: Seeing their stock go up without them in it or having it go down with them still holding. Typically, it is the latter that they fear. A wise man once said, “You will never get hurt taking a profit.” I agree with that sentiment. There needs to be a balance where you give a stock enough room to keep you in it if it is going up and keep the stops tight enough to get you out before a big down move. As with everything in trading, the key is discipline. As long as you
  2. 2.   3 develop your strategy for setting stops and stick to it, you will be giving yourself the best chance at success. If you buy and sell at random then you will not be trading stocks for long. I know a guy that just learned firsthand why it is so important to remain disciplined. He had no problem buying stocks but when he did, he got scared. So he would set his stops way too tight and get stopped out right away. He got so frustrated that he stopped putting stops in and then he had a stock move three points against his position him. If he would’ve kept putting in the tight stops he would have been around even and if he would have not put stops in at all, he would have actually been up a lot. Instead he acted randomly, without a plan, and ended up down money. Now, the best thing he could’ve done was follow a strategy for setting stops that would’ve allowed him to allocate a proportionate amount of risk/reward to each position. He could’ve maximized his results by holding the winners and dumping the losers. The key is, knowing how to set those stops. Let’s find out… A Stop Order or Stop Loss is designed for your protection. If the stock is terrible and you’re not paying attention, a well-placed stop is what prevents a small loss from turning into a major disaster. A simple buy and hold strategy is no longer a viable option. One of the main reasons I have so many students is that they bought stocks and a couple of years later realized that their hundred thousand dollar portfolio was only worth thirty thousand. The market is like the ocean, it’s fun and exciting but if you are not paying attention then it can be extremely dangerous. Volatility One of the key criteria for setting a good stop is assessing the volatility of the stock itself. For example, if you were to set a stop in Google (GOOG) at thirty cents below the market then you would just be throwing away money. Google can have a bigger
  3. 3.   4 spread (the difference between the highest bid and lowest offer) than thirty and you could be out of it seconds after you bought it. If you are buying a stock because you believe it is going up then you want to give the stock enough room to prove you right. If it’s an extremely volatile stock then you need to realize that there is going to be above average risk in the trade, which will require you to space out the stop and give the stock room to move around. If you are not willing to take on that risk then you should avoid the stock. If the stock is a slow mover then it wouldn’t make sense to give it more room. For example, if the stock is at twenty and a huge move would be two points then you might want to only take on thirty cents worth of risk. There should always be a good risk vs. reward scenario. We’ll discuss risk/reward later, but for now let’s stick with assessing the volatility. One easiest ways to determine a stock’s volatility is to look at its trading history. Is this a stock that tends to move three points in a day or would twenty cents be more likely? What are the volume tendencies of the stock? Typically, higher volume stocks are less volatile because there are more people involved in the stock, therefore less fluctuation. When there are less people involved there is more room for big moves. When I’m talking about high volume vs. low volume, I would consider anything over ten million high and anything around 500 thousand shares traded per day relatively low volume. Please understand that you can have a stock that only trades 50 or one hundred thousand probably because it’s not in play and not going anywhere. These stocks are typically news driven and subject to a random jump or drop. This is not the risk/reward scenario that a beginner should be looking for. Price is another factor that determines volatility. A higher priced stock simple logic. A 10% move in a twenty-dollar stock is two points and a 10%
  4. 4.   5 move in a hundred dollar stock is ten points. That’s why I recommend beginners start by trading stock within a 10-50 dollar price range. To trade a seventy or eighty dollar stock properly might require more risk than you are willing to take on. Please understand that a twenty-dollar stock can move points in a day or more but it is more common in a fifty-dollar stock. Notice the chart below. This is a news-driven stock that often focuses on a binary event (FDA approval). In trading there are exceptions to every rule. The last thing I want is for you to think you are completely safe trading a twenty-dollar stock simply because it is a “twenty-dollar stock.” However, the more factors going your way, the more likely you are to correctly determine the volatility of the stock. The volatility of an industry and sector of an individual stock is also going to affect the volatility of specific equity within said industry/sector. Similarly, a twenty or thirty-dollar stock in the oil industry will tend to move around a lot more than a similarly priced stock in the brokerage industry. Oil is constantly in the news and the stocks trade in a wide range. If you are watching a stock “in play,” in a given sector then you need to realize that there will probably be a lot of movement in that stock relative to the sector’s movement.
  5. 5.   6 For example, a few years ago, when Microsoft announced they were buying AQNT. AQNT moved from approximately 35.00 to 63.00, which caused related stocks like VCLK and TFSM to surge as well. When a sector/industry is in play, the stocks are going to have more movement than normal. If you bought VCLK in the previous example and did not give your stop enough room then you probably would have been shaken out and missed a two point up move. So remember to evaluate: previous history, price, volume, and industry/sector performance to determine the volatility of the stock and subsequently where to set your stops. Risk vs. Reward and Stops Everything in trading is risk vs. reward. You never want to have proportionate risk to reward, meaning, it should not be a 1:1 ratio. You want to risk one point to make four or more. After you have established your resistance level, you must determine whether or not the trade is worth it to enter. For example, if a stock has just gone from 25 to 29 over a 2-week period and there is a clear resistance level at 30 then the trade doesn’t make sense. You have levels at 25 and 30 and the stock is at 29. So you would be risking 4 to make 1. Because of the proven resistance, we would not enter that trade (long). Now, let’s say the stock clears 30 and the next level of resistance is 35. Now we may have a trade. We can buy at 30 and look to set our stop below the level. If it’s a fast moving stock then we might set our stop around 29 and risk 1 to make 5. If it moves 2 points every 6 months then we might only give it .50 cents. The goal is to keep the risk proportionate to the reward. Now when the risk vs. reward changes we need our stops to change as well. If we bought this stock at 30 and it went to 32 then we wouldn’t leave our top at 29. If the next stop was 35 then why risk 3 to make 3?
  6. 6.   7 We want to maintain a good risk vs. reward ratio; so in this case, we might move our stop to 31. We are risking one to make 3. In this example, our worst-case scenario is now making a point. Remember, good stocks keep you in them, if you place your stops correctly (adjusting for volatility) then you will stay in.
 By moving your stop on an up trending stock, you are ensuring a profit; While at the same time, not guessing the top. You’re giving yourself a chance to stay in for a big move
 without risking your profit! This will take practice and discipline; make no mistake. The system works, it’s up to you to make it work suitable to your investment objectives and risk tolerance. Your greatest challenge(s) will be to set Stop Loss orders; the consequence: A “Hope the position will eventually move in your favor.” We’ve all done it. Remain disciplined! ALWAYS CUT YOUR LOSSES WITH A PRE-DETERMINED STOP! Here’s an example of what a good stock looks like: Once it starts to go up, a “good stock will keep you in it.” By placing your stops strategically below significant levels you could’ve been in this stock from 60 to 100 or even 120. This
  7. 7.   8 strategy also allows you to keep your sanity. By staying disciplined and taking the same approach every time you don’t miss out on all of the high flying stocks and you don’t get caught in all of the one day wonders that return to earth minutes after blasting off. When setting your stops, remember to allow for a good risk/reward ratio and to maintain that ratio by adjusting your stops when the stock moves up. Obviously you should not be adjusting your stops on the way down. When the stock hits your stop then you are out and can look to reenter at a strategic point. Modern Day Tips When you are setting your stop, you have to use some creativity. There are so many computer programs permeating the markets that you must allow for the volatility they cause. If you have programmed stops in at the price of 30 then as soon as that stock hits 30, thousands of orders are triggered at once and the price will drop. This does not mean that 30 is not a resistance level. It means that if it does break below then it will come right back up. That’s why you can’t set your stop at 29.99. Use the volatility of the stock to determine where to set the stop. Some will be .25, .50 or a point below. Let’s expand on this modern day theory. Sometimes they will bring the stocks down in .25-cent increments. This means your stop should be slightly below that. So if your level is at 29.75, put your stop at 29.70, instead of 29.50, do 29.40. This extra ten cents could keep you in the stock and have you make an extra 3 or 4 points. I knew a bunch of people that traded HANS. It once had a critical 35 level. Some beginners put their stop at 34.90 and some of the more experienced traders put their stop in at 34.40 (based on the volatility and risk/reward). The stock hit 34.87 and then turned
  8. 8.   9 back around. All of the 34.90 stops were knocked out which was unfortunate. Because the stock went to 40, fifty cents cost people five dollars. On one hundred shares, they cost themselves 500 and on a thousand shares they cost themselves 5000. Remember this when deciding where to set your stop. If you set your stops correctly and avoided that little shake out move then you had clear sailing to 45. FAQ on Stops 1) What happens when a stock goes through a 52 week high? Use the old high as a new downside resistance level. If the high was 50, that is now your base. After assessing the volatility and risk/reward, you can set your stop at 49.40 or 48.70. 2) How do I set a stop in a stock that has gone straight up and there is no recognizable resistance level that is close to the current price? Great question; if you just have to have in on the high flyer that has gone straight up then use a day slightly below that.
  9. 9.   10 3) If a stock has bad news after the market closes I will just be stopped out at my price, right? Wrong. Stops only work from 9:30AM to 4PM so don’t assume you can hold a stock with imminent news pending and your stop will protect you. Stops only work during market hours. If you have a stop limit then it will stop trying to sell beyond your limit but that can be dangerous. A market stop will get you out of a stock at the first available price after hitting your stop (which could be significantly lower if bad news happens over night). This hurts if the stock shoots right back up but can save you a lot of money if the stock continues lower. 4) What do you think of trailing stops? I don’t like them, especially for a beginner. Here’s why. Let’s say you own a stock at 40 and have a .50-cent trailing stop. If the stock goes to 41 and then down to 40.50 you are out. It’s just starting to move for you and get stopped out? It doesn’t make sense. You no longer have the proportionate risk/reward that you want.  

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