Last weekend I suggested that it was probably better to use stops than not for most retail traders. While these orders may yield imperfect results at times, I remain convinced that their use is generally much preferred to the alternative of exits by emotion. That does not mean, however, that I believe that setting stops is easy. It isn't. Setting a stop can be more an art than a science and often does involve subjectivity.

Though picking the precise level at which the stop will be set may involve some subjective judgment, at least it can be done when the trader can take his time and reflect. It can be done before a position is ever entered and when the markets are closed. In short, the decision of precisely where to place a stop can be made even before the trade is entered. In my view, that is precisely the time to decide on the placement of the initial stop and the trader's strategy for moving the stop if the play goes in the desired direction.

What factors should the trader consider when making the decision where to place the initial stop? Clearly, the first decision is how much the trader is willing to risk. Though the stop does not guarantee a sale at the stop price, in many cases the order is executed fairly close to the stop price. However, the trader must always be aware that the stop is no guarantee of a price and the actual price could be far from the stop in the event of a gap. When the trader evaluates a trade, he should have a plan in place that includes the possibility that the trade will go against him. In that event, what amount or percent is he willing to risk. Some commentators advocate an exit 6% or 8% below entry. If that is the trader's personal plan, it seems obvious that the initial stop should be placed 6% or 8% below the entry price when the trader is going long. If the stock is being purchased for $40 a share and the trader is using a flat 7% exit, the initial stop would be placed at $37.20.

Another trader may not want to put $2.80 a share at risk on a $40 stock so she might choose to use a break below support as an exit. For example, suppose a stock has a price support at $39.70. The price has hit that level 4 times in the last 8 weeks and bounced up each time. Our trader sees it bounce up again near that level and buys the stock at $40. She could certainly decide that she wants out if the stock breaks down through the support and may choose to set a stop somewhere below that support level. Perhaps she would choose to set the stop at $39.50, reasoning that a little dip below support can be tolerated but anything more than a little dip is a break through support and a signal to get out. This trader would be exposing about 50 cents a share compared to the earlier example where the trader was willing to risk $2.80 a share. Neither is necessarily wrong; it is purely a matter of the personal plan and risk tolerance.

An initial stop could also be placed below a trend line and the stock purchased on a bounce up off the same trend line. In that case, the position would be held until and unless the trend line is broken. This example incorporates both an initial stop and a strategy for moving the stop. The initial stop is just below the trend line just as every move of the stop will continue to be. Of course, as long as the trend line is moving up, so, too, will the stop be moved up. Some traders may move the stop up each day; others may do so only once a week. Once again, the decision as to how to implement the strategy of moving the stop up is a part of the individual trader's personal business plan. The key is to have the plan and implement it.

As may be obvious, many traders are quite aware of levels of price support and trend support and so many stops are placed near these levels. Market makers, too, are aware of where the stops are located. At times we see situations where a stock price dips, hits a pile of stops and then the direction turns back up. The stops are sold and the stock takes off. Is there manipulation? No one would ever admit to it. Unfortunately, a dip that hits stops is part of the game. Though I have not done any research, my gut tells me that the phenomenon may be more likely to occur with the less liquid (lightly traded) issues if there is, indeed, any manipulation.

Once a decision is made regarding the placement of a stop (before the position is entered), I advocate checking to see the next level to which the price has indicated it may move. That is, in the case of a bullish move, where is the next resistance. That becomes an important level because it is a target. Now we can measure how far away our entry price is from initial exit and how far it is away from the target. I like to see the distance to target (reward) approximately 2.5 times the distance to initial exit (risk). Now, I have a potential reward to risk ratio. I should note that just because a price hits a target does not necessarily mean one should exit. It could keep going. As the price approaches the target (resistance), that is a reason to move the stop up tighter. If the price hits resistance and turns down, I'll be stopped out. If it goes on through resistance, I am still in for the ride.

Good Trading!
Bill Kraft

October 27, 2007

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