If I Get a Tattoo on My Hand It Will Be a Reminder to Set a Stop!
Setting a stop is the most important task in trading. It’s also the hardest.
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Everyone agrees that cutting losses is the most important rule in trading. Almost nobody does it well. Setting and honoring stops is a good example of my maxim that if it were easy, it wouldn’t have the potential to make you rich.
The stop process has two steps. The first step is setting the stop point, and the second step is actually selling when the stop point is hit. That sounds simple, but it presents several challenges.
Most Traders Never Set a Stop
The first and most important issue is that most traders and investors never have a clear stop. They don’t even consider that the great stock they bought might not turn into a winner. They are convinced it is fundamentally solid, and if it goes down, they think the market is making a mistake, not them.
Not only is there a reluctance to set a stop level, but there’s also the conundrum of where to set it. One size does not fit all when it comes to stops, because volatility varies widely from one stock to the next. A tight stop may work well with a slower-moving big-cap name, but it will be too easily triggered in a higher-volatility, low-priced small cap. A 10% pullback may be normal volatility in some stocks, while it would be a major move in another.
Where to Set It
Two main approaches exist for setting stops. The first is to use a set percentage drop. William J. O’Neil’s CANSLIM methodology uses a stop at 7% to 8% below the purchase price, but that may be too tight in more volatile names and then there is the issue of adjusting the stop to protect profits.
The second approach is to use a technical level, such as the 9-day or 50-day simple moving average, depending on the trade’s time frame. Other technical approaches use breakout points or chart gaps. There are numerous ways to design a stop, but what is most important is consistency.
Whichever approach you use, the stop should determine position size, not the other way around. If the right stop for a volatile small cap is 15% away, you buy a smaller position so that a 15% loss costs you no more than you are willing to lose. Traders who pick their size first and then squeeze the stop to fit it end up with stops so tight that normal volatility knocks them out.
Choosing a stop level is a difficult decision and requires some judgment, which is why many people never even bother with it. Typically, they have a vague idea of where they will dump the stock if it doesn’t act right, but then the stock starts to fall, and they talk themselves into holding on because it is still fundamentally solid. When it keeps sinking, they regret their lack of discipline but tell themselves it is too late, so they might as well hold on and hope it recovers.
This is probably the most common and most costly mistake in trading. If you don’t have a clear stop level, you won’t act on it. So set the stop when you buy. Look at the chart, find a level that makes sense, and watch it.
Taking the Stop
The discipline of actually acting on a stop is complicated by a couple of things. First, you may be reluctant to set hard stops with your broker. There is a justifiable fear that the stop level will be targeted and end up being the stock’s exact low point. That is the Market Beast at work. The Market Beast will do its best to make your life miserable, and there is no way to avoid its wrath.
Without a hard stop, however, you have to watch the stock closely. Often, the stock will plunge through a stop level or gap down overnight, and instead of being stopped out with a 10% loss, you are now looking at a 20% loss. You freeze in disgust and dismay as you ponder what to do.
There is a middle ground. You can set an alert at your stop level, or use a stop based on the closing price, so that an intraday shakeout doesn’t take you out. The alert or the close makes the decision, and then you carry out the sale. The cost is slippage. By the time the close confirms the break, the stock may be well below your level, and you have to accept that as the price of staying disciplined.
There is a saying, often attributed to motivational speaker Jim Rohn, that applies well to the stop problem: “We must all suffer from one of two pains: the pain of discipline or the pain of regret. The difference is discipline weighs ounces while regret weighs tons.”
The discipline of stops hurts because, in many cases, they’re suboptimal. The stop will hit, and then your precious stock will immediately turn around and go straight back up. But when you fail to honor a stop and the stock keeps sinking, it will cost you far more than the small losses that come with the discipline of a stop.
And a stop doesn’t have to be a goodbye. As I wrote last week, a remount strategy is a good way to return to a name that triggered an exit. If the stock sets up again, you can buy it back. Knowing that the door stays open makes it much easier to take the stop in the first place.
Stops Protect the Next Trade
If you want to be a great trader who produces exceptional results, you have to embrace the idea of stops. The common cop-out is that you are focused on fundamentals and valuation, and price action is just noise to ignore. That thinking turns small, manageable losses into portfolio-crushing mistakes.
Your long-term success depends far more on stops than on buys, because it is the stops that protect the precious capital you need to buy the next great stock. My best advice is to be mindful of the importance of stops.
I’ve often considered tattooing the word “Stops” on the back of my hand so I never forget. Don’t enter a trade without one.
At the time of publication, DePorre had no position in any security mentioned.
