Friday, October 13, 2006

Stop placement

If I am going to use the trailing stop for a certain trade. What percentage should I use? or there is another way of installing this feature? what is it?

Placing stops is always a tricky subject. Much of it depends on the risk threshold of the individual, as it is the projected plan for the trade (short term hold, swing trade, long term/investment).

The bulk of my suggested trades fall into the intermediate/swing trade category; with failed plays often holding for less than a month (often weeks, or days); successful trades tend to close inside 6-months. I give a suggested initial stop price for stocks featured in my newsletter (some of the most recent picks are available for free here):

In some cases, I will feature a stock more than once over this period. Stops are nearly always raised, and in some instances the target price is revised upward too. But what of the bulk of trades which fail to make the grade for a second (third, or fourth) time - how can one employ active stop protection?

When I was studying for my CMT level II exam, part of the course included the work of Phil Roth. Phil Roth talked about using ADX in conjunction with the Parabolic SAR. From what I can remember (I don't have the book in front of me - so someone can chime in if I am wrong on this), positons were entered when the parabolic SAR trigger was hit and ADX rose above 20. Positions were held in the direction of the trend as long as the ADX > 20; positions were exited on a cross of +DI/-DI, or if the parabolic SAR was hit when ADX < 20. This kept the position in a trending market, but exited it when the stock moved sideways. I keep ADX and parabolic SAR information on my charts, which can be viewed on my public Stockchart list (remember to 'Vote for the list!' at the bottom of the linked-page if you visit).

Another strategy is to use zig-zag retracement. This can be set at your desired risk threshold - but the more volatile the stock, the greater the chance for whipsaw on a retracement. In the below example I am using 8%, but you can see a stock like GIGM gives quite the nail-biting ride. So this strategy is not for everyone.

One could use slow stochastics to set stops. Again, there is flexibility to set the parameters one could use to define where stops are set. In the CRS example, I am using standard slow stochastics set at [14,3]. The aim is to place the stop at the reaction low associated with each 'buy' trigger in stochastics. A faster stochastic will mean a tighter stop - but it will also leave the trade more prone to whipsaw. I do include the slow stochastic setting [14,3] on my charts, which people can use should they wish.

For investors, this system can work very well on a weekly chart, although it can be tricky picking out the 'buy' triggers when stochastics are overbought (I had to use the magnifying feature) and deciding where the reaction lows are. Switching between a daily and weekly chart would help in this regard. But, its another tool one can use.

An alternative strategy is to set stops at the prior reaction low as the stock makes new reaction highs. I have used the weekly chart of Casual Male (CMRG) as an example. A series of white candlesticks is treated as a continous move. A white candestick followed by a red candlestick, which is above the previous white/red candlestick combo, is a new reaction high. Picking the prior reaction low can be tricky and hindsight made this easier to do than it would probably be in the heat of the moment (which is one reason weekly charts are better for this); for example - I could have placed "Low 3" around the $7 mark, which in this instance, is a substantial percentage difference relative to where I had it at $6. I am sure many will have different opinions as to where the reaction high/lows are in the example I have given - but it is just to show another method of setting stops.

Going back to my newsletter example; stops can be set 1% away from support, and if resistance is breached; 1% away from this. From there - the target price shouldn't be too far away.

Finally, the point-n-figure chart can provide very clean stop prices. Similar to using new reaction highs, one can trail a stop at each lowest price of a pattern breakout, or point-n-figure buy signal.

Hope some of this helps!