Stop Orders for Getting

As soon as we own a stock or have shorted a stock, we need to be thinking about where we want to or have to get out. That is, we want to if it goes with us, and have to if it goes against us. I believe there is only rarely any reason to get out of a stock using any method except a stop order. By following that regimen we are conforming to our thesis that the market is always right, and we are just trying to go along with it. The rare exceptions might be when we are looking at such an extreme situation, and such a compelling chart pattern, that sitting around waiting to give it back makes no sense. That would most likely be seen if a stock suddenly formed a gap and then traded in very heavy volume in a very narrow trading range. It would look like an exhaustion gap, as described in Chapter 13. But that is rare. Usually the stop order will serve you much better. Almost always it will be better to admit we are never going to catch the extremes, and only want a piece out of the middle of the move.

TYPES OF STOP ORDERS

We are going to look at three different types of stop orders to exit positions. They are all very closely related and very similar, but their placement is a little different in each case. They are:

1. Stop-loss orders

2. Trailing stops

3. Profit-taking stops

First let us look at the stop-loss order. It is typically placed soon after a position is entered, and is designed to protect against a move in the wrong direction and to correct a mistake in entering the position. Many people set their stops at a particular percentage away from the original entry level, saying that they will not accept more than a predetermined percentage risk. The problem with this practice is that all stocks do not have the same level of volatility. In one company a 10 percent move is gigantic, while in another it is commonplace. If an investor will not accept more than a certain amount of risk, it is better to select stocks that are likely to be less risky, rather than to arbitrarily impose that percentage on every stock. Stop levels need to be tailored to each individual situation. When I am considering a possible buy, I first determine where I want to put in my entry stop order. Then, before doing anything else, I determine where my stop-loss order should be, based on the stock, its chart, and its history. If the potential loss is larger than I feel comfortable with, I eliminate the stock as a possible trade.

There are a number of other, much more sophisticated ways of placing stops based on such methods as standard deviations. The use of standard deviations is better than a set percentage because it is matching the stop to the nature of the stock. However, I feel the best approach is one of logic. We know a great deal about the typical price action of a company, based on chart patterns and volume characteristics. I would rather tailor the stop levels using that knowledge than rely on a mathematical formula.

I am bothered every time one of my stop orders to get out is executed. I shouldn't be, because it is part of my plan, but I always do have that feeling. It seems, at the time, as though it is a sign of failure. I have been taken out of a stock because it was going down when I thought it should go higher, or I was taken out of a short position because it was going up when I thought it should go down. That is what makes this discipline difficult to follow. Almost always, within a few minutes, hours, or days, I am congratulating myself on getting out before I was hurt much worse. And even though I am aware that it usually works that way, it is still not easy to watch a position be taken away by a stop order. In the preceding chapter we were talking about stop orders to get into a position, and the fact that it was psychologically difficult to offer to pay up for a stock when it could be bought at a cheaper price by just guessing at the likely up move. But, in that case, it is a new position without the additional psychological burden of ownership. Once I own a stock I have made a commitment, and I want to be right. Even if no one else knows what I am doing, I feel somewhat accountable to myself. For that reason, the most important rule in placing stop orders to get out is to place them immediately. The first instant you own a stock is the time when you can be the most objective about it. As soon as you have owned it for a little while and watched a few up or down moves, it becomes more difficult to decide unemotionally where to place the stop. That is another reason I prefer to have already determined my stop-loss level before I even enter the stop order to get in. Then, as soon as I have a confirmed entry, I immediately enter the predetermined stop.

LOGICAL ORDER PLACEMENT

Stop-loss orders should be entered based on the chart. Looking at the picture, I ask myself what would have to happen for me to know that I had been wrong in entering the position. Then I give it a small amount of leeway from there, to allow for extraneous ripples, and set my stop-loss level. Usually the first determination gives me a round number, but knowing that round numbers have an uncanny way of being touched, I usually give the stock a few cents of room away from the round number.

Because we are generally buying a stock because of a power box, the placement of the stop is likely to be obvious.

On the chart of Citigroup in 2006 (Figure 11.1), we have a very common scenario. The horizontal line is the resistance level going back many months. It is decisively penetrated in early December, with a large trading range and heavy volume. There can be little doubt that this is a power box. It pulls back for just two days, but that gives us time to determine the slope of the descending top of the consolidation. So the stock is bought when it moves up through that descending line the next day. This is a great setup, because the stop can be placed below the last level of support, which is just about a point below where we bought. The risk is therefore only about 2 percent. If the stock decides it is not going up, we will be taken out with a small loss, but the stock has already told us it wants to go higher. In this case it did, indeed, move sharply higher, producing a good profit. That is the nice thing about using small flags, rectangles, and pennants after a breakout as an area in which to be buying. In the case of a flag or rectangle the stop is quite close to the

FIGURE 11.1 Breakout through Resistance.

entry point, and in the case of a pennant it is extremely close to the entry point. Yet a change of direction has occurred, so we are in harmony with the rhythm of the stock.

On the chart of CEC Entertainment (Figure 11.2), we have two examples, one a short and the other a long. The first is brought to our attention by a power box to the downside; it becomes a candidate for a short sale. The next two days give us a small flag, but, as is usual with a flag during a decline, it is waving up rather than down. The break below the bottom of the flag triggers a stop sell to get us into the short position. That leads us to immediately place a protective stop just a few cents above the last resistance level, the top of the flag. From here the stock continues lower, never hitting our protective stop and allowing us later to move that stop lower.

Two months later we have a new situation, in which the stock has shown us a power box to the upside. After that strength, the consolidation is a small pennant rather than a flag. We are put into the stock when the upper limits of the pennant are broken. Because the lows have been ascending, we are able to place our stop-loss order very close without going against the conclusions we reached through our analysis.

These are all examples in which the stop order was placed but never used. There are times, though, when the stop serves its purpose of minimizing our losses. We see that in the chart of Champion Enterprises, in Figure 11.3.

Everything seemed to be favorable as this stock broke out with a pair of heavy-volume up days. The pullback was a typical flag that lasted about three weeks. The breakout above the descending top of the flag put us in at a favorable level, and we

IIGIRl 11.2 A Short and a Long.
FIGURE 11.3 Minimizing Losses.

would have immediately placed a stop just below the prior low. From there the stock did move higher, but then failed. As we will see next, we might have moved the stop up below each of those small pullback lows, thereby capturing a profit. But, assuming we did not, we would have been stopped out when the stock started to go back down. The result would have been a loss, but a very small loss. The protective stop did its job.

I suggest readers take time to go to their computers and bring up, randomly, a large number of charts, looking for power boxes and identifying the subsequent consolidations, and then establishing logical levels for initial stop orders. It is surprising, doing this exercise, to observe how few of those stops get picked off immediately. In most cases the price continues to move enough to provide a profit and to allow for the protection of that profit by moving the stop. The trick is to move the stop enough to protect the profit, but not so much as to be taken out prematurely.

TRAILING STOPS

Basically, after the original stop is placed, we want to move the stop in the direction that continues to protect more of our money. Each time a minor pullback and resumption of the move is seen, we want to move our stop to a point just beyond where the turn occurred. The assumption is that both an up move and a down move are a series of steps, each progressively producing a little more profit. That means, though, that we cannot act immediately. Only after the stock has had time to make its next pullback do we have the information to know where the next turning point lies. It is never correct to move the stop order down in a long position or up in a short position. That is called rationalization of an unfavorable move. The first placement of the stop was the detached and unemotional one. The idea is to follow the move and be taken out as soon as a lower low in an advancing stock or higher high in a declining stock is seen.

Look, for instance, at the chart of CIT Group (Figure 11.4). Throughout the entire move the stock never made a pullback low until the advance finally came to a decisive conclusion. There was one pullback that made a very similar low, and would have been worrisome, but turned out to be just a resting phase about midway in the advance.

Of course, sometimes it does not work that smoothly. Consider the chart of Geron Corporation in 2006 and 2007 (Figure 11.5). Here we followed the rules. We bought on the top of the flag, after the power box. We placed our stop and then moved it up once when a higher low was made. But then, even though the stock went higher and we had no lower lows, the pullback in early December wiped out all the paper profits from the prior two months. It did not make a new low, so we held on and later moved the stop up once more, finally getting out in January with a small profit after all. Sometimes the system of putting your stop under each pullback low will get you out too soon, but generally it is effective. It is not a bad thing to get out early if you have a profit. The fact you were taken out implies the stock is not acting as expected or hoped. You can move the money to another situation, a new power box, and start the process again.

FIGURE 11.5 Geron, 2006-2007.

PROFIT-TAKING STOPS

The problem with a trailing stop such as we have just looked at is that it tends to leave quite a bit of money on the table at the end of the move. The reason for that is that very often the final part of an advance or decline is an accelerated move, leading to a spike. The top or bottom of that spike can represent a large part of the overall move. That is why I also have included the possibility of placing a profit-taking stop. This order should be entered only when it looks as though the move has gone too far too fast. It is not based on the pattern of ascending lows or descending highs; it is based on the desire to maximize profits while still allowing for more progress in case we are wrong. As an example, Figure 11.6 shows Principal Financial's stock in early 2007.

It had been a strong uptrend, so a long position could have been followed nicely with a trailing stop order. Then the stock seemed to shift to high gear and trend upward with a much steeper pattern. It could still be followed with a stop below each pullback to protect the gain. However, then it posted a very square Equivolume entry that penetrated the ascending trend line. That was a strong indication that the stock had encountered heavy overhead resistance. The exiting stop would have still nailed down a good profit, but it looked better, at the time, to give the stock almost no room to move back down, and thereby to maximize profits. A plain sell order would have removed the opportunity to profit if the advance continued, but a close stop would get the stock sold at the least sign of weakness. The latter is what happened.

FIGURE 11.6 Maximizing a Profit.

A profit-taking stop can maximize profits, but it carries the danger of getting out too soon in a very strong stock. The technique should be used only in unusual circumstances, and we should guard against using it as an excuse to give in to our natural inclination to nail down a profit. It borders on second-guessing, which we do not want to do.

Remember to never be long or short any stock without having a stop order protecting you. Early in the game it can save you from a big loss. During the move it will protect you from the unexpected unfavorable move that can erase much of your gain. And late in the game it can help you to maximize your profits. Moreover, you can walk away from the markets and go on a vacation and know that you are not likely to be badly hurt.

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