Don’t get unduly stopped out by the markets

Here we go for another technical post. Let me start first by answering a question: no, I will not post videos because text and pictures make you think, you can even print them if you wish. Though video can be a very good tool to show something, if you can not write it down with simple words, then you just have no clear idea of what you are talking about. So read, read again, think, confirm and write down your ideas, progress! This is the way this blogs intends to help you, dear readers!

I am going to discuss today trader’s least understood tool: the trailing stops. Because it gives a false sense of security, trading apprentices may loose lots of money, and even go broke if not careful.

There are a few conditions to use a trailing stop:

  • A trend should already exist
  • The stock or selected security should have the capability to trend (refer to history)
  • you know what you are doing!

Let’s look first at the performance of a trailing stop used as standalone tool:

As you can see, the performance over 20 years for Apple is absolutely ridiculous, especially when compared to 3-SMA and volatility system!

Why is that? When the stock is not trending, prices hover over and sink below the stop very fast, causing losses each time. Even a good up move will have hard time to catch up for losses. Even if your stop is carefully engineered, the behavior will be quite bad in flat markets.

Fair enough, how am I supposed to use stops now? You need the WWW stop technology! Don’t worry, you can use this one even on Yahoo finance:

For the example, I used the Moderna stock which became known to public right at the top of the graph!

Now add not one but three ATR trailing stops!

  • The Red one: the Wake-up call (2 ATR’s below price here). As name implies, its goal is to wake you up from time to time and make you think! You have to decide whether you stay and do nothing, stay and increase your line (pyramiding), or take a partial gain or get out. It is YOUR DECISION!
  • The Blue one: the Warning stop! (4 ATR’s below price here) When prices go under this one, you should definitely consider stepping out before it hurts too much!
  • The Green one: the Waouh stop (6 ATR’s below price here). This one has 3 objectives:
    • it tells you about the trend: see how Moderna was above of the stop for most part of the graph
    • you are sizing your line based on this stop
    • It is your hard stop: exit! But your loss might be greater than expected! Enter it in the trading system if you can not monitor the market for some time.

You should always have an exit strategy and the exit is based on a sole parameter: the max pain level you can stand!

Say for instance that your pain threshold is 100$. Just buy a number of stock so that, if the green stop fails, you will loose 100$ (you might need to get a round number of stock). Simple mathematics: say stop is 20$, close is at 25$, so a risk of 5$ per stock, so invest no more than 100/5=20 stocks!

If prices close below the blue stop, you may get a loss but it won’t hurt (too much!) because you will loose less than 100$

Of course, as trend starts picking up, all stops will go up, which will void your risk and you can decide to increase line size, always carefully checking that you can’t loose more than you pain threshold!

Note that you replace the Waouh stop by anything you like, could be the low Bollinger band, the low band of a Keltner channel, … whatever makes you safe and will follow the trend at good enough distance so you are not missing major market moves!

Remember the rules for trailing stops:

  • Size the line according to bearable pain
  • Use stops only when a trend does exist
  • Make sure you get warnings from the market before the stop is hit

That’s it. Until next time, trade safely!