The Importance of Setting Stops

Let me share with you a story and ask if it sounds familiar.

The Phone Call

Liz called me devastated one afternoon. “I think I’ve blown it for good this time. I don’t know what I’m doing. I should just quit trading. I’m destined to be a surgery nurse for the rest of my life.”

I asked her what was going on and she went on to tell me about a trade she had just completed. It was on Hess Corporation: HES. She entered the trade on October 17 @ 79.60. It was a morning gap after a reversal candlestick formation. She was convinced this one would be a winner. By the time she called me the week before Christmas her $75, December Call options had expired worthless. Over $10,000; poof, gone, expired, worthless; and worthless is how she felt.

In reality, Liz was not (and is not) worthless. What she was is desperate. Desperate to feel progress. Desperate to get ahead in her trades. Desperate to feel confident that she will not be the reason for her financial demise. Desperate to find answers and not re-live this pain.

Can you identify with Liz? Unfortunately, this story about Liz is far too common. I can sit here on the outside and immediately make observations about what happened. I can immediately point out holes in her trade and pinpoint why and where she set herself up for failure. Of course, at this point what does it matter? The financial damage is done, and the emotional damage is starting to take a toll.

Without a critical plan of action, this trader will become a washed-out casualty of the market. The good news is with a few small tweaks she can turn these losing trades into winning trades or at the very least she can make trades with a very limited downside loss.

How You Ask?

For starters, Liz made several assumptions on this trade that ultimately led to a huge loss. The first was her assumption that oil had to go back up. Liz could not understand why oil was so cheap and she just “knew” that oil had to go back up. The bullish candlestick patterns and the morning gap were all the confirmation she needed to enter this trade and hop on board for a bullish run.

Liz Entry

The next assumption Liz made was the assumption that if it did not go up immediately, it would go up eventually. She held on to the trade, even after it gave very clear signals that it was bad, hoping (and praying) that the trade would go back up.

In addition to the two assumptions, she made two fatal mistakes. The first is she bought an option contract without considering the reality that eventually this option would expire. She treated it just like a regular stock, and when the 3rd Friday in December came, she suddenly remembered options do expire.

Finally, she made the mistake of not doing a complete analysis. An analysis that, if she had done it, would have told her this stock was in a clear bearish trend with no signs of reversal - regardless of what she thought about the price of oil.

In the end, it was a toxic stacking of errors — one that cost her a lot of money, and a lot of emotional distress.

Now here is the interesting conundrum. Like most people, Liz was worried about the loss of her money. But the money isn’t important. I’m not worried about the loss of her money - I’m worried about her loss of confidence and the emotional turmoil she has put herself through.

Yes, there were problems with the trade. But the real assassin had nothing to do with HES, the stock market, options, the price of oil, or anything else. The real assassin was the fact that Liz made and managed this trade with pure emotion. I would love to say Liz is an isolated case, but the reality is most traders are just like Liz. They make bad decisions based on emotional reasons and never have presence of mind to realize they are the reason for their loss, not the market.

The Human Element

I think there may be only one thing human beings hate more than losing money and that is admitting they lost money because they made a wrong decision! It is the deep human need to be right, mixed with the deep human desire not to lose money, that leads people to enter a stock trade and hold on for dear life, even when they know this trade is destined to be a loser.

We have all heard quips about how the stock market eventually goes up, and if you hold on long enough, your trade will turn back into a winner. Unfortunately, this isn’t the case. Some stocks never come back. Some stocks may come back eventually, but it may take 8-10 years. This uncertainty leads to sayings like “buy hold and pray!”

Of course, the uncertainty can be eliminated on the front end by simply placing a stop order with your trade. But then, that opens up an entirely new world of conspiracy about market makers running stops and high-frequency traders scalping 1/32 of a cent off your trade and somehow making it impossible to make money.

These conspiracies are a waste of emotion, in my opinion. And yet they are completely understandable. After all, when dealing with stock trades, we are dealing with two things that every human being values possibly above all else:

  • Money
  • The ability to make quality decisions.

Now let me bring clarity to what I just said. I said, “every human being values possibly above all else.” Certainly, I will get hate mail about how we value family or love or world peace above money and being right. And I agree that when we consciously answer the question about what we value, wonderful things like family and love and world peace are the first thing that leaves our mouths.

But when I talk about values, what I am talking about is needs.

The survival part of the human has a much deeper need to have certainty about basic survival than we have a need for family or love etc. Ask a person who has been trapped under an avalanche for two weeks with no food, no certainty of rescue, no water except for that which can be melted from the snow - that person will very quickly reveal that while friendship might be nice, it’s not more important than survival.

In our modern world, money is a critical tool for survival. AARP recently cited a study showing more baby boomers are worried about running out of money before they die, then they are dying. The need for survival is so strong and so linked to money that the bible even goes so far as to warn that the love of money leads to all kinds of evil. Certainly we see all around us people doing all kinds of evil to try to meet their need for money.

But another need that is central to survival is the need to feel confident to make the right decision. A person who lives in constant fear of making the right decision is a person who fears the consequences of making that wrong decision. This goes back to our need for survival.

Understanding these basic human needs and trading psychology from this point of view, it is easy to see why a trader really does not want to lose money, and why a trader really does not want to admit they’re wrong. It is against our human nature. Consequently, traders, by nature, do not want to use stops because it both locks in a loss and reflects a perceived lack of ability to make quality decisions.

Protection from Self-Sabotage

Self Sabotage

Now here is the paradox - the trader who holds these values will guarantee their undoing as a trader.

The challenge with the stock market is it requires us to be wrong often. AND being wrong often will manifest itself in the mounting of many losses of money. To the trader who does not have this understanding and has not learned to manage it, this reality will be their undoing.

So a trader who wishes to be profitable in the stock market, and one who wishes to maintain a long term future as a trader, must learn to put boundaries on their trades. The boundaries have much less to do with the stock or the market itself, and everything to do with protecting the trader from him/herself.

If we went back to the story of Liz, we can discover a handful of blind spots that led to her losses. But the biggest blind spot was the way she managed the trade. Yes it’s true, she entered a trade she should have avoided, and she entered it for the wrong reasons. But holding on to that trade and hoping it would come back simply because she didn’t want to take a loss, that was a much bigger mistake.

When a trade goes bad, the trader who is upside down in the trade only has two decisions.

  • Take the loss and preserve what remains.
  • Lose more.

However, since there is real money on the line, few traders are willing to take either of these choices. Instead they fabricate a 3rd choice - Hold it, and maybe it will come back.

The moment the trader takes this choice, they have officially moved from the position of “market trader” to “gambler.” Sometimes the gamble pays off. Frankly this is the worst result possible because it leads the trader to believe that this was a real choice. But it never should have been a real choice. It is results like this that lead people like Bill Gates to say “success is a lousy teacher.”

Success breeds confidence. It can also breed confidence in a bad strategy and lead a person to believe they can continue that strategy and get similar results.

When a trade goes bad, before a trader can consider holding the trade, they have to ask themselves “if I were not already in this trade, would I take it today?” If the answer is no, which 99% of the time it is, then the trader has zero reasons to hold the trade. Simply holding the trade because it will cost money to close it is a lousy reason to hold a trade.

So what can we do as traders to protect us from ourselves?

It all comes down to trade management.

I have a good friend who is a fund manager, and he once told me “give me an excellent analyst with bad trade management skills and I assure you he will lose money. Give me a bad analyst with great management skills and he will make money year after year.”

Most retail traders focus on “picking the right stock.” This is a losing battle. They’re all good stocks. Realize that you can look at any stock on the exchange and somebody is trading the stock and somebody is making money. So asking the question “which stock will make me money” is a very low-quality question.

A better quality question is to ask “how do I know when this stock (whatever stock) is about to break out into a new move.” Now that’s a better question. And you can answer that question through good trade analysis.

At TradeSmart University, we teach five steps to trade confirmation. When all of the analysis starts to line up, the probabilities are high that this trade will be moving in the direction you want.

It is for this reason that we do not advocate massive stock scans but rather prefer a watch list with a handful of stocks you are willing to trade. Watch that list and wait for the right trade to confirm. Over time this is a much more profitable way to trade and makes for a much better trader in general.

Simply choosing a stock before it breaks out, however, does not make you a winning trader. What does? Managing the trade.

​Traders Must Manage the Trade.

    There are three critical price points every trade should have before you enter it.

  • The entry price: the price at which you plan to enter
  • The target: where you expect the trade to go
  • The price where you will stop out.

Your stop price should be the price where you know the trade has gone against you. Consequently, there is little or no reason to continue holding this trade. If you hold a trade after the price has moved through your stop, you are saying to your trading account “I know this is a bad trade but let’s gamble it and see if it can work.” If I was your trading account I wouldn’t work for you either with that attitude!

Your stop price is one of the most important tools for every trade. Every professional trader I know advocates (requires) the use of stops. Without a stop, we are expecting ourselves to be able to make a quality analysis and trading decisions during the absolute most vulnerable time - after we have already started losing money.

​Why not go into the trade beforehand knowing how much is the most you are willing to lose on the trade? This is how professional traders do it, and it is how you should do it as well.

If you enter a trade at say $169.50/share and know your target is close to $199, then you know you have a $30/share profit that is your likely reward. But what about your risk? Are you willing to hold the trade through a 25% retracement to make $30/share? It sounds ridiculous when you read it, yet millions of traders do this very thing every day. They hold through a 25% retracement HOPING to make it to their target of $30/share. No wonder so many traders feel the market is against them and they can not make money.

However, what if you looked at a trade and said: “if this stock drops below $159/share it is no longer a bullish trade”. Well why not put a stop order at that price? Now you know the most you should lose will be at, or around $10/share and your target profit will be at or around $30/share.

Stops Example

The time to determine this is before you place your trade, not after you have already started to lose money. If you wait until after the trade starts down, the natural human inclination will be to keep lowering the stop and hoping the trade will come back. Before you know it, you’ve held through a 25% retracement. At this point, who cares about making money? You want to get out and break even!

Can you identify with this emotional cycle? If what I’m saying hits a little too close to home, please do not feel bad. You are no different than the majority of market traders.

Remember earlier when I said Liz was just a few tweaks away from being a great profitable trader? This is the first tweak. If Liz had recognized the trade had gone against her, and if she had closed the trade - or better yet if she had the computer do it automatically - Liz wouldn’t have lost everything. Sure, she may have lost some money. But I would much rather lose 10 or 20% of an option than 100%! By this time Liz herself would agree!

​Just Stop the Madness!

When put in place and allowed to work, the stop order will protect you. Most people call it a “stop-loss” because it stops the loss of the trade. Supposedly it protects our capital. I prefer to say it “protects us from ourselves”!

Without the use of a stop, the human nature is too strong. We make excuses. We fabricate stories as to why this would be a good deal now. We look for made up fundamental data to support our claims. And to be a bit gory about it - we find ourselves willing to go down with the ship.

There are several types of stops. The most important thing is that we actually use a stop. I also find it valuable to talk about which types of stops are most beneficial. I’ll outline and define the basic stops here:

The Basic Stop Order

This is essentially a trigger. It says, “if the stock hits this price, then sell my stock at a market price.” I generally prefer this type of stop, over the stop limit because when a trade goes against you, I don’t want to dilly dally around - I’m ready to get out of the trade. Let’s get it over with regardless of the pain. In a bullish trade you will set your stop price below your entry, and in a bearish trade your stop price will go above your entry price.

The Stop Limit

The stop limit is like the stop order, except when it triggers the closing trade, the stop limit triggers a limit order instead of a market order. This has pros and cons. The pros are you can specify the price at which you are willing to sell, and you can plan your losses better. It avoids slippage and all things considered creates a more predictable balance sheet. The con is the reality that a stock will often gap over or under your stop, and if you have a limit order sitting there, your trade is not going to get filled. For this reason I prefer the basic stop order.

These are the basic type of stop orders. There is, however another type of stop order that is included in most broker platforms which is worth mentioning: the trailing stop.

The​ Trailing Stop

The trailing stop is a type of stop order where the stop price continues to adjust higher (or lower if it is a bearish trade) as the trade moves up higher and higher. The basic principle is to lock in any profits with a trail of “x%” or “x” dollar amount.

For example: Let’s say a 5% trailing stop is placed. Maybe the stock starts at $100. 5% lower would be $95, so the stop would be placed at $95. But during the course of the trading day perhaps the stock increased to $105 before settling the day at $102. $105 was the highest point, and thus, the 5% trail would be set off the high point of $105. By this point the stop has been automatically increased to $99.75 (5% less than the high mark of $105).

In theory, this stop practice locks in profits and makes for a more profitable trade. In practice, I have found it not to be the most profitable way to place stops as the trade usually closes on a down tick and very often it is stopped out long before the trade is complete.

This brings up an important question.

“How do we know which price point to set the stop”?

The answer to this is slightly more complicated than this article, but I will give a bare-bones answer. For a more complete understanding on how to know which price point to set your stops check out this webinar “Using stops to protect your capital.”

Generically speaking the initial stop placement will depend on if you are in a bullish trade or a bearish trade. In a bullish trade, we want to stop out if the trade goes down, so the stop will be placed below the entry price. In a bearish trade, we want to stop out if the trade goes up, so the stop will be placed above the entry price.

Now the million dollar question: How far above or below?

The general principle is that we need to set the stop at a price point where we know the trade has gone against us. This price is most easily tied to support or resistance. In a bullish trade, if the stock drops too far below support, we know the selling pressure is likely resuming, and we should abandon the bullish trade.

In a bearish trade, the opposite is true. If the stock breaks too far above resistance, we know the buying pressure is likely to resume, and we should abandon the bearish trade.

Following this general principle is a very good place to start. It is best if you do not set the stop exactly at support or resistance. Rather allow a little bit of buffer room for some normal intraday volatility. Look at the recent candles and notice how high or low the recent candle shadows are, and this will give you a pretty decent idea of how big your buffer should be.

The price for your initial stop should not be changed, unless you have a very good reason to do so. Once the trade starts to move in the right direction, you can adjust the stop manually to better reflect the needed protection for the trade.

Wrap Up

Avoiding our human nature is not possible. However, what we can do is put boundaries around our trades to protect us from our own emotional sabotage. The stop order is a very important tool available to every trader that when utilized properly will help the trader better manage the trade as well as limit the potential loss from a trade. Get very comfortable using stops because, without them, you may as well be opening yourself up to unlimited risk.