searching for the ideal stop

When you invest, you want to protect your investments. Therefore, people use stops. Not using stops is like driving a car downhill without brakes. Colleagues often argue that stops are bad because you get stopped out too early and miss the following move up. I usually ask them “what kind of stop are you using?” I get answers like

• No stop
• Fixed amount stop
• Percentage stop
• Average True Range stop (“ATR”)
• Trailing stop

So what is the “ideal” stop? If you have absolutely no idea, try the popular indicator (“Supertrend”) often used as a good way to start:

It is a good start, but often late, or in volatile sessions, you will miss out the upper half of the move. Plus, it does not start when you buy a stock, but it has fixed rules for long and short stops.

I have tried all sorts of stops and came to conclusion, that one single stop is not working for me, instead, I use a combination of stops. It requires coding, yes, but it is worth it.

So my stop system looks rather like this:

Initially, as you buy share, you have to ask yourself “what is my personal risk tolerance?” or “how much am I willing to lose if my analysis is completely wrong?”

Some people have a fixed percentage amount (e.g. 10%), others use an ATR. Keep in mind that if you trade volatile (e.g. biotech) stocks that your ATR may be bigger (e.g. 18%) than your personal risk tolerance. I suggest you to use the minimum of the two. At the same time, a trailing stop is in place. Keep the fixed stop in place until the trailing stop surpasses the fixed stop. Now you can switch and follow the trailing stop instead.

But what trailing stop to use?

Again, there is a variety of choice: fixed amount-, percentage-, ATR-, … -trailing stops

Which one is “ideal” mainly depends on what you are trading. My personal choice is an ATR-trailing stop as it considers the volatility of the underlying.

The advantage of a (long) trailing stop is obvious: it moves up along with a stock, but never moves down. Thus, it looks in profits while protecting the investments downside.

So where to start your investment? Typically, you can find an entry the traditional way, e.g. a MACD-V crossover:

So you would buy in point (1) and move your trailing stop along on the way up.

In this particular example, you would be stopped out ahead of the MACD-V sell signal in point (2) giving you a nice ~8% profit advantage.

Is the trailing stop always better?

No.

Sometimes the trailing stop is giving you the better profit, sometimes the indicator sell signal. There is no general rule for it. Eventually if you keep trading the same asset over and over again, you may find out what works better for you, but in general, market price action decides.

Don’t forget: when you get stopped out, it is like you hit “pause” on your music player. The market takes a rest, eventually reverses, but it could as well resume its price action in the direction of the previous trend. Just as you have a “stop-loss” in place, you should also have a “stop-buy” in place, ready telling you when the move resumes.

I have made great experience using stops and over time, I found many ways to customized it even further. What is “risk”? To me, risk is only what you cannot control. Stops are a great tool, but don’t be lulled into a false sense of security: stops are not the holy grail of zero risk, because they don’t protect against gaps. You can minimize this risk only by diversifying into several securities.

++Happy Trading++