A Guide to Protective Stop Losses
By: Oliver Velez
The following is an excerpt from Oliver Velez’s Trade for Life
Protective stop losses. You have read about them. You have been lectured about them. You still don’t use them properly. What do you do? The purpose of this lesson is to go into more detail and say more than just "you must use them." I will try to explain why you may not be using them properly, and give suggestions for new ways to use them.
Let's get a few facts out first. Fact number one: most traders do not make it in the long term, especially those who do not get training. Fact number two: most traders who fail do so due to not following their stops. Fact number three: your goal is to get to the point where you follow stops like a reflex, just like you would jump out of the way of a speeding car. There is no in between. Either you follow them or you don’t. I will offer suggestions to reach this goal, but they are not substitutes for this goal. You must accept that you have a flaw and that it needs to be fixed.
What is a stop loss? It is a line in the sand, right? A spot which is chosen to represent the maximum loss on a trade? Not completely. Most people don’t realize that the stop loss comes from the chart. Depending on the play, some may have tight stops and some may be wide. You really need to know the stop first, so you can play the right number of shares so your maximum loss on a trade is within the limits you have set in your trading plan. You can't change the stop because that would violate the integrity of the play. You can adjust your share size to make the potential loss within your limits. You can pass on the play if it does not fit into your plan. You may not realize it, but this is the first step in following your stop. Have a trade and share size you can live with.
Consider trader Jane. Once upon a time she bought a stock as it broke out from an all-afternoon long base. Her stop was below the low of the base. The stock started up, and then pulled back to the base. Then the stock fell below the base, then below the stop. In disbelief, Jane just froze. This was a perfect set up; it just couldn’t fail! Now the stock really plummets. She can't sell now; obviously, it can't go any lower. She doesn’t want to sell at the low of the day. So she hangs on. The stock starts to come back. It rallies back to the base, then back above. It turns out to be a big winner.
This is a problem for Jane. In my book Tools and Tactics for the Master Day Trader, I call this "winning the wrong way." It does not matter how many times Jane now loses money by violating her stops. She will always remember this one winner. That is the way the mind works, it remembers what it wants. In the Pristine Method® trading room, we are big on teaching the tracking of trades and printing charts and identifying mistakes. By doing this you would know that, most of the time, violating a stop results in more losses. Jane may go on violating stops because she remembers only that one time – the one time her loser became a winner.
Consider trader John. Maybe you can relate to his story. He goes long on a stock. It never goes quite right. The futures start slipping. His stock hits his stop. He does not sell it because he feels he is an experienced trader and his stock deserves a little more room. After all, his stock is holding up well, it is just the futures that have slipped. If they come back, surely his stock will do well. If he sells now, it is likely to come shooting back. And because he is in the trade, it is worth a little more investment to give it a chance. Does this sound familiar? The stock does not come back much, and John starts looking at his stop. He realizes that his stop was awfully tight, and just a little bit lower is a major area of support. So he makes that his new stop. Of course, that stop comes close, and he now looks and realizes that the low of the day is not far below, and that will be solid support. That will be the final stop.
Of course, as that stop gets violated, John starts thinking that he can't sell it now: it can't get any lower, and it is due to bounce. Besides, the daily chart has support in this area. Finally, in some truly sad situations, John may start looking up the fundamentals of the company. He has taken a scalp off of a five-minute chart and now has an investment. How did this happen? Does any of this sound familiar? Looking back, that original stop was not such a bad idea.
So what do we do? First, have a trading plan. You need to have outlined how many shares you can trade with a stop loss at a certain point. This strategy ensures that you are trading with a share size that allows you to take a loss when needed.
Second, have your plan and all of your rules in writing. Your plan should be very specific. It should be written as a promise to yourself. Your mind responds differently to the written word. It truly does. You must write and review your rules and keep a top 10 list every week. If your rule is simply to always follow stops, but it is not working, try this:
By selling half, it lets you get into the habit of doing what is right, while appeasing the terrible place in your mind that does not want to be a loser. You will find it easier to sell half. Once you sell half, your mind will start thinking properly again. If you cannot get rid of the back half, you must sell by the end of the day. Never hold a loser overnight. That is a career stopper.
In summary, have a trading plan. Define what you are allowed to lose on a trade. Define what your share size can be on a trade. Define what your goals are so your subconscious knows what being a loser is. If you are three for seven in winning trades but you made money, are you a loser? Write your rules and learn to follow them. Sell half for now if you can't sell it all. You must get to the point where stops are automatic and reflexive. Finally, never, never take home a loser.
Always remember, that there are many people who held positions from $250.00 all the way to $10.00 or lower over the last three years. Did people intend to do this? Did they use plays with $240.00 stops? Of course not. Most of them entered a day trade with a tight stop, and did not honor the stop when it hit. Once that happens, it becomes harder and harder to sell at any level. This is why we call the stop an "insurance policy." Do not ever let this happen to you. If the market falls for the next 12 months, where will you be exiting your swings? Are you sure about that?