This chapter covers:
Why you must limit risk and protect profits by using stop-loss orders (“stops”) on every trade
What will happen if you don’t use stops
How to set stops
How to use market conditions, stock-specific factors, and context to decide how tightly to set stops
How much loss you should tolerate on any trade
How to use trailing stops to protect profits
How to recover from a bad loss
TRADER TALK A stop is an order you can place with your broker to sell a stock you own if it drops to a specified price. It’s called a stop because it stops you from losing any more money on the position. If you’ve sold short, you can place a stop order to buy to cover if the stock rises to a specified price.
Get into the habit of thinking of the market as a construction site. It’s a work in progress that goes through many different phases, and lots of unexpected things happen there. Sometimes things that looked perfectly stable in the morning fall down in the afternoon. Things that looked solid suddenly come loose and slide to the ground. In fact, you can count on “accidents” happening at regular intervals. Every so often there’s bound to be one; the only thing you don’t know is when or how the accident will come.
Just as you must wear a hard hat while working in a construction zone—unless you’re a half-wit or suicidal!—you must protect yourself when you work in the market. As a trader, your protection is the stop-loss order, or “stop.”
Without protection, the stock market is not a safe place for your money. Forget anything you’ve heard to the contrary.
During bull markets and early in bear markets, many people find it incredibly hard to understand that the market will not keep their money safe. They believe that, no matter what, the market and “good stocks” will “always come back,” as though this were a law of nature.
There’s no such law of nature. Stocks don’t always come back. The market doesn’t always come back. If you think about it a little, you should start to ask yourself things like this: “Why should a stock continue to go up forever? Does anything in this world go on forever? Can a company’s value reach infinity?” If you want to think about the market in terms of laws of nature, the best one to have in mind is the law of gravity: “What goes up must come down.” This is especially true for stocks and sectors that have risen extremely fast, beyond any rational relation to value.
Falling stock prices can wipe out your capital so fast you won’t know what hit you. Here are just two examples of what can happen when you least expect it, and how things actually can be worse—much worse—than you ever imagined.
Consider the following charts based upon actual market events during March and April 2000 (this was even before the bear market truly took hold).
Celera Genomics (CRA) dropped 70 percent in only four weeks, helped by a statement by Bill Clinton and Tony Blair on March 14, 2000, favoring free access to human genome sequences and calling on genomics researchers to make their data freely available. Celera’s business plan was to make money through patents on its genomics databases.
Think that’s bad?
Microstrategy Inc. (MSTR) dropped 60 percent in only one day after announcing that its quarterly results Wouldn’t meet analysts’ estimates. Changed accounting methods (read: accurate accounting) had forced it to restate revenues and operating results. (The same day, it changed its 1999 full-year results from a profit of 15 cents per share to a loss of up to 51 cents per share—quite a different story.)
Such volatility is common in today’s markets. That’s pretty obvious, and everybody knows it, but they all seem to think it won’t affect their stocks. This is the kind of thinking that leads people to buy a bunch of stock on margin and then lose their entire investment (and probably owe their broker a little above that, as a kicker) when everything suddenly turns south.
And sudden crashes aren’t the only kind of stock market disaster. There’s also the horror of a slow, grinding ride down over a period of weeks and months. Look at the chart for just about any technology or dot-com stock between spring 2000 and spring 2001 and you’ll see losses of 50 percent, 75 percent, even 90 percent. Some charts won’t even be available because the companies have gone out of business. Let me list just a few that are extinct: EToys.com, Pets.com, Mother-Nature.com, Garden.com, WebVan. Dozens of companies, including some that were real hotties in their glory days, have been delisted. The only people who’ll remember these stocks in a few years are the ones who lost their entire investment or much of it because they never knew when to get out. They didn’t have a plan to bail at a certain point by limiting their losses.
They didn’t set stops.
Losing the money you put into a trade isn’t the only kind of disaster stops can stop. There’s another one: making a great trade, running up a nice paper profit, and then watching it slip away until you actually start to lose money on the trade. Think this can never happen to you? If you don’t use stops, it can and it will.
A classic Mr. Loser adventure will illustrate this particular horror show. Mr. Loser buys a boatload of Orbit Galactic Corp. for $10,000 and watches the little rocket ship double in price in only three days. He’s made $10,000 in three days, and he’s ecstatic! The stock then weakens and falls a little, but he doesn’t want to sell it yet. He thinks, What if it turns around and goes up another 50 percent? That would be worth another $5,000. It would suck to miss out on that profit! So he keeps holding Orbit, hoping (how I hate that word!) that it will recover and continue to the moon. He holds and it drops, and he thinks about how much he wants his profit back, and he holds some more and it drops and drops some more, and he finally ends up losing money on what had been a very profitable trade. This should never happen to a trader, but it actually happens all the time.
What was Mr. Loser’s mistake?
He didn’t protect his profits with trailing stops.
Both of these unspeakable horrors—losing your capital and losing your profits—are completely avoidable if you protect yourself with stops.
Stops are not complicated. When I use the word “stop,” I’m referring to a stop-loss order. This is an order that directs your broker to sell a stock you hold long if it drops to a specified price. If you’ve sold short, you can place a stop-loss buy-to-cover order to get out of the position if the stock rises to a specified price. Once the stop is triggered, it’s immediately executed as a market order.
Here’s an example. Let’s say you buy TechniDaydream, Inc. at $50 a share. You have reason to think DDRM is going to make your financial dreams come true, but you also realize it’s a risky trade. You know that if the stock drops much below $48.50, it means there’s trouble with the trade and you’ll want out. How can you be sure to get out if the stock drops below $48.50?
After buying the stock, you place another order: a stop sell order at $48.40. This tells the broker that any DDRM execution in the market for $48.40 or less is an automatic trigger to sell your shares immediately in the form of a market order—they’ll be sold at the current bid, whatever that is. This will happen automatically, which means you won’t have to watch the stock like a hawk just so you can bail quickly. It also means you won’t be tempted to hold on just a little longer and a little longer still, hoping(!) that the stock will go back up.
TRADER TALK In general, there are two types of stop orders: stop-loss and stop-limit. (Check with your broker; some brokers use slightly different names for various order types or may not offer all order types.)
A stop-loss order is an order to sell a stock if it drops to a specified price, or to buy to cover a stock you sold short if it rises to a specified price. Once the stop is triggered, the order is executed immediately at the market price (it becomes a market order).
A stop-limit order is an order to sell a stock at a specific price and no lower than that price if it drops to that price, or to buy to cover a stock sold short at a specific price and no higher than that price if it rises to that price. Once the stop is triggered, the order is executed only if it can be executed at the limit price or better (it becomes a limit order).
WAXIE’S STREET SMARTS
Don’t use stop-limit orders. There’s no good reason to do it, and it needlessly increases your risk. If a stock’s price is dropping fast, chances are great that a stop-limit order won’t execute at all.
Let’s say DDRM does drop instead of making your dreams come true. It hits $48.40, and your stop is triggered. Your stop order becomes a market order to sell. This means that it will execute immediately at the current bid price.
The same principles apply to stops on short positions. If you sell Fester Corp. short at $13, expecting it to go down, you’ll place a stop buy-to-cover order at, say, $13.75. If Fester suddenly goes on a feverish rally, you’re protected—and you can always reshort the stock at a higher price when you believe it’s cooled off.
TRADER TALK To stop out of a position means to exit the position because your stop order has been executed.
Let’s go back to the long position in DDRM for a minute to see what might happen. If the stock is falling slowly, the market order may execute at $48.40, slightly lower, or even slightly higher (in theory—although this doesn’t happen too often). If it’s falling quickly, it could execute a little below $48.40. If the stock is falling like a brick, it could execute a little below $48.40 or quite a ways below it.
This is one reason some people avoid using stops: They don’t like the possibility that they could stop out far below the trigger price. Although this does have the potential to suck, what’s the alternative? Would you rather keep holding the stock while it goes even lower? I don’t think so! Besides, in most cases you’ll stop out quite near your trigger price.
The one exception to the rule of having stops in place at all times is that you should never leave a stop in place overnight. The reason is the opening gaps up and down (see Chapters 3 and 4). If the stock gaps down, this volatility can needlessly cause your stop order to be filled as much as 20 percent below the price where the stock will eventually stabilize that day. This is discussed in more detail below in the section on trailing stops.
In addition to fearing a bad execution price, some people are afraid that, following some corollary to Murphy’s Law, the stock will start to go back up immediately after their stop sell order’s been executed. Setting stops under support levels, as discussed below, will help avoid this problem. A stock may still occasionally bounce right at the point where you set your stop, just as a random occurrence, but the smart trader weighs this occasional frustration against all the times she’ll save much more money by using stops to get out of losing positions. Think of it as the cost of insurance.
Nothing in life is free. Insurance is no exception. Using stops as insurance will occasionally cost you a little, but it will save you many times more in the long run.
WAXIE’S STREET SMARTS
Never leave a stop in place overnight.
Stops limit your risk of loss on bad trades. Put another way, stops enforce the important discipline of taking small losses and getting out when stocks go against you. Some traders find that they are unwilling to take a loss on any stock. They don’t want to admit that they were wrong. Who does? I sure don’t. But staying in a bad trade and letting it lose you money is sheer pigheadedness. I’d rather admit I’m wrong than have my stubbornness cost me a bundle.
What often separates a good trader from a bad one is the ability to take small losses. Your goal must be to take small losses and make big gains. If you do this diligently, you’ll become a profitable trader. But, you ask, what if you stop out of a stock you still want to trade? The answer’s simple: You can always buy it back later, most likely at a better price, if the trade still has potential.
Seems like common sense, doesn’t it? What’s the big deal? But so many traders just don’t want to bother setting stops, or are afraid they’ll stop out of some great trade. Also, many traders are unsure of where—how tightly—to set their stops. It’s true that setting stops is an imprecise science and involves lots of trial and error, but in this it’s no different from buying insurance for your property or your health. Should you avoid insurance altogether just because you’re not sure exactly how much something is worth, or because it will cost you a little money? I think not! You estimate and do the best you can, and the insurance will cost you something—of course!—but it will be well worth it. I’ll tell you more about where and how to set stops below.
And again, remember what I told you in the last chapter. If you want to trade, you must be able to take small losses. You don’t need to win on every trade. And never, never marry a stock!
RULES OF THE GAME Be able to take small losses.
RULES OF THE GAME You don’t need to win on every trade.
RULES OF THE GAME Don’t marry stocks.
Besides limiting risk and helping you take small losses, stops are incredibly valuable because they can protect profits on winning trades. As I said in the last chapter, you must develop the discipline of locking in profits. You can enforce this discipline using one simple technique: trailing stops.
RULES OF THE GAME Lock in profits religiously. No one ever went broke taking profits!
Remember how Mr. Loser managed to make a winning trade on Orbit Galactic Corp. but then lose all his profits and more?
How can you prevent that from happening to you? (And believe me, if you don’t have a plan, it will happen.) The answer is to use trailing stops. This means that once you have a profit, you move your stop nearer to the current price so you’ll stop out with most of your profits intact if the stock turns south. What if the stop executes and you decide you want to trade the stock again? Easy: You buy it back at a better price than you sold it for, and then ride it up again. That’s how a good trader makes and keeps money.
TRADER TALK A trailing stop is a stop order you place below the current price of a long position, progressively moving it up as the price of the stock increases so that the stop follows the stock up. For a short position, you set a stop above the current price and then move it progressively down, following the stock as it dies.
Setting stops is both an art and a science, and there aren’t many hard and fast rules to follow. Here are a few guidelines to keep in mind as you practice and develop the skill of setting stops.
Be aware of individual brokers’ rules
Some brokers have rules about where stops can be set. For example, some have a rule that protective stops must be set at least a minimum amount below the current bid when you’re long (stop sell), or above the current ask when you’re short (stop buy-to-cover). For example, the rule may be that a stop sell order must be at least .25 below the current bid. This is generally not a problem with a high-priced stock, but with a very cheap stock, when every quarter-point is worth a lot relative to the share price, you might not be able to set a tight stop unless you wait for the bid to move up. In addition, if the price of a stock is dropping quickly, the bid may come too close to the stop you’re trying to place before you’re able to place it, causing your order to be rejected.
Another rule some brokers have is that stops can’t be set more than a certain percentage lower than the current bid (or, on a short, higher than the current ask)—for example, no more than 30 percent lower (or higher). I have no idea why you’d ever want to lose 30 percent of the value of your trade before stopping out, and I would never set a stop anywhere near that low.
You’d think it would be impossible to place a limit order when you mean to place a stop, but it’s actually quite possible when you’re in a hurry. Since you should be in the habit of using limit orders to enter positions, placing them should be almost second nature. That’s why you need to make sure you don’t enter a limit order out of habit when you mean to place a stop-loss. If you place a limit sell order at a price below the current bid (at the place where you meant to place your stop), it will execute right away and you’ll be out of the trade.
NEWBIE TRAP When you’re in a hurry, it’s easy to place a limit order out of habit when you mean to place a stop order. Always review orders carefully before placing them. Look at your order again and think it through one last time!
Don’t set stops overnight
Remember what you read in Chapter 4 about the NASDAQ’s volatility at market open? Most mornings, NASDAQ stocks either gap up or gap down from their prices at the previous day’s close, and then they swing pretty wildly as overnight market orders (placed by the foolish) are filled. For example, a stock could close at 33, open the next day at 32.8, drop to 31.94, and then bounce back up to 33.15 before stabilizing and finding its direction. It could also close at 33 after a good day, open the next day at 33.75, spike up to 34.50, and then drop back to 33.60. Or it could close at 33, open at 32.8, and then spike up to 34.12 before dropping back to 33.8. You get the idea.
If you have an overnight stop in place on a long position, it’s likely to be triggered by the morning’s volatility, which will stop you out at the low end just before the stock bounces back up. You need to assume that there will be a gap at market open and remove your stops after the market closes, resetting them after the opening volatility the next morning so they will protect you from real downside rather than routine fake-outs. Don’t leave stops on overnight.
You might also consider doing what lots of traders do, especially when the market has no consistent direction: simply avoid holding many positions overnight. Once you get better at anticipating what will probably happen the next day (realizing that there can always be overnight surprises)—and at recognizing when there’s no way to anticipate what will happen—you’ll feel more comfortable making these judgment calls. As always, if you don’t have a pretty good idea what will happen, it’s best to avoid the situation completely: When in doubt, stay out!
NEWBIE TRAP Don’t place tight good-until-canceled or overnight stop orders that will be triggered by the volatility of a gap up or gap down at market open. Wait until the market has stabilized (after 10 A.M.) before tightening your stops for the day.
WAXIE’S STREET SMARTS
If you’ll be unable to trade for several days (for example, while you’re on vacation), consider whether it makes more sense to set stops or to exit your positions altogether. Unless you’re in a great long-term trend trade and the market has a definite direction, it may be better to exit all positions and start fresh when you return to trading.
Decide how tightly to set stops
The most important question about setting stops is how tightly you should set them—how close to the price where you entered the position or, for trailing stops, how close to the current price. This is a general decision you’ll make before you figure out exactly what price will be your stop trigger. How tightly to set stops depends on several factors:
How much you’re willing to lose on a single trade. My rule is that you should never lose more than 2 percent of your trading capital on any one trade.
How risky you believe the trade is. If you think the trade is a sure winner and market conditions are favorable, you may give the stock more room to move down before triggering a stop. If you think it’s got only a fair chance of working out, or if the stock has serious tankage potential, set a tight stop (or don’t make the trade at all).
How volatile the stock is. If the stock routinely moves up and down in a range of 15 percent or more over the course of the day, even when it’s not really going anywhere, you can’t set tight stops. If you do, you’ll be knocked out of the position by the stock’s normal volatility. If the stock is choppy but too risky to trade without tight stops, maybe you’d better look for a better stock to trade.
How cheap the stock is. When a stock is dirt cheap, even the smallest decimal price movement will be fairly large in percentage terms. This means tight stops may be knocked out more easily. It also means that if your broker has a rule that you can’t set a stop closer than .25 below the current bid, you may not be able to set a tight stop until the price moves up.
How much money you have in the play. You should consider this in conjunction with the rule that you should never lose more than 2 percent of your capital on any one trade. If you have a large amount of money in a play, 2 percent may be much more than you’re willing to lose. If so, you should set stops accordingly. If your account is small and you’re not well diversified, a 2 percent stop may be so tight that you may stop out immediately. If this is the case, you should review Chapter 2 and think seriously about whether you have enough money to trade.
Market conditions. If the bulls are running like exuberant wild things, tight stops may not be necessary. If you’re trying to go long in a bearish market, tight stops are absolutely necessary. If the market is choppy—if it has no clear direction or if it’s full of nervousness and fear—use tight stops (and ask yourself whether you should be trading at all that day).
The time frame for the trade. On a quick day trade, tight stops are a good idea. On a stock you expect to hold for a week or two for a trend play, they may or may not be, depending on other factors you’re aware of.
What you have reason to think will happen to the stock. If you have reason to be confident that the stock will move upward even if it swings around a bit first, it doesn’t make sense to set a tight stop because you’ll just stop out as it swings. If you think it might possibly move up but will definitely tank if it slips below a certain price, then tight stops are a must.
WAXIE’S STREET SMARTS
Never lose more than 2 percent of your trading capital on any single trade.
Which of these considerations is most important? Since no two trades are the same, different factors will dominate on different trades. Think about all of them on every trade. If you don’t, you’ll miss something important. Your job is to exercise good trading judgment and figure out what makes sense for each trade. This is where the “art” of setting stops comes in: You have to experiment a bit and learn what works for you. You’ll occasionally stop out of a trade too soon and feel frustrated, but remember: This is just the price of insurance and, at least at first, of education. You’ll get better and better at setting stops as time goes on.
Your ultimate goal is to develop flexibility in your thinking so that each new situation makes sense to you on its own terms. This is how you’ll become a nimble trader who can trade with the market.
Set stop sell orders below support
The one fairly specific rule in setting stop sells—the “science” part—is that you should not set them either right on the stock’s support level or just above support. Instead, unless the support level is so low that stopping out there would lose you too high a percentage of your capital, set stops below support.
TRADER TALK A support level is a price at which the stock has previously bounced (reversed its downward course). Think of it as a potential floor. See the chart below for an illustration.
Micron Technology, Daily – QCharts ©2001 Quote.com
Support.
Copyright © 2001 Quote.com, Inc., a Lycos Network site. QCharts is a registered trademark of Lycos Network. All charts or trading products or services mentioned herein are those of Lycos or their respective owners. All rights reserved.
Don’t set stops at or slightly above a support level. Set them below support.
The reason it’s so important to set stops below support is that stocks moving downward tend to bounce upward (reverse course) at or near their support levels. They may later begin to move downward again, break through support, and continue to move even lower.A clear break below support is dictated by where a stock closes, not by intraday swings. Alternatively, after bouncing off support, a stock may continue to move upward, never returning to the support level at all. For purposes of setting stops, it doesn’t make sense to set a stop right at support because the stock is almost certain to bounce up from that point, possibly reversing course. If you set your stop below support, it probably won’t be triggered unless the stock has broken support and will continue downward.
WAXIE’S STREET SMARTS
A clear break below support is dictated by where a stock closes, not by intraday swings.
The same principle applies for a stop buy-to-cover on a short position: Set your stop above, not at or below, resistance.
TRADER TALK A resistance level is a price at which the stock has previously reversed its upward course. Think of it as a potential ceiling. See the chart on page 180 for an illustration.
WAXIE’S STREET SMARTS
A clear break above resistance is dictated by where a stock closes, not by intraday swings.
Motorola Inc, Daily – QCharts ©2001 Quote.com
Resistance.
Copyright © 2001 Quote.com, Inc., a Lycos Network site. QCharts is a registered trademark of Lycos Network. All charts or trading products or services mentioned herein are those of Lycos or their respective owners. All rights reserved.
As a general rule, an old resistance level that’s been broken through on an upward trend will serve as a new support level. Likewise, an old support level that’s been broken through on a downward trend will serve as a new resistance level.
WAXIE’S STREET SMARTS
As a general rule, old resistance becomes a new support when resistance is broken and old support becomes new resistance when support is lost.
Intel Corporation (NM), Weekly – QCharts ©2001 Quote.com
Old resistance becomes new support
Copyright © 2001 Quote.com, Inc., a Lycos Network site. QCharts is a registered trademark of Lycos Network. All charts or trading products or services mentioned herein are those of Lycos or their respective owners. All rights reserved.
Here’s an example to illustrate the reasoning behind decisions about where to set protective and trailing stop sells.
Protective stop
First, to illustrate the importance of setting stop sells below support: Let’s say you take a long position in Web Acknowledgement Ltd. (WACK) in anticipation of its earnings announcement. It had traded at around 13 for many weeks, but last week it ran up to 16, probably as the first sign of its earnings run. It then slowly dropped to 14.4 over the course of two days and stabilized there for a day and a half. Today it’s started to slowly move up again, and you think it’ll keep going. You decide now’s the time to buy. You put in a limit buy order for WACK at 14.8, and it executes at 14.76.
Since WACK isn’t the strongest company in the world and the market has been iffy of late, you want to set a reasonably tight protective stop. You don’t want to set it too tight, though, since the stock isn’t too volatile and the time frame for your trade is about five days. You look to see where the stock has support.
There are two support levels: 13, where WACK traded for weeks, and 14.4, where it stabilized recently. Its resistance level is 16. If the stock moves down from where you bought it, it will almost certainly bounce at 14.4. If the stock then drops below 14.4, you figure that would indicate that it isn’t ready to move up yet, and you’d be better off stopping out there and rebuying later. For this reason, you also figure there’s no reason to let the stock move all the way down to 13. Since its support at 13 is very solid, any drop through the floor at 13 would mean a real weakness had developed in the stock.
You decide to set a protective stop at 13.75. You don’t want to set it right at 14.4, since it’s almost sure to bounce near 14.4 and then either start back up or continue down. You don’t want to set it above 14.4 for the same reason. You choose 13.75 because no support level is absolute, and WACK could bounce off 14.3, 14.5, or any number close to them as easily as it could bounce off 14.4. If the stock gets as low as 13.75, though, that would suggest that the stock will actually break through support. (Remember, the rule is that a clear break of support is dictated by where a stock closes, not by intraday swings.)
Trailing stops
You made a good call! WACK motors up to 15.1, stays there a while, suddenly dips sharply to 14.43, and then picks up volume and really goes to town. It breaks through its new resistance at 15 and starts the climb to 16. The market is rallying.
Now’s the time to start to think about using trailing stops to protect your profit. You’re starting to accumulate a nice one: At 15.50, you’ve made 5 percent, and if the stock hits 16.24, your profit will be 10 percent. You decide that the stock should stay above its old resistance of around 15 unless trouble is brewing. (Now that the stock has broken through its old resistance at 15, that price will serve as a new support level. Remember, old resistance becomes new support.) You move your stop up to 14.85.
The stock could pull back a bit at 16, since that level served as the ceiling before. When the stock nears 16, you’ll have a choice: either take profits by selling out directly or setting a very tight trailing stop, or increase the looser stop trigger to 15.3 in anticipation of a further move upward.
You decide that, since at 16 WACK will already have moved up almost 25 percent from its longtime price of 13, it may not blow through 16 so easily. You decide to set a tight stop once it hits 16 instead of selling out, just to give it a chance. So once WACK hits 15.7, you move your stop up to 15.2; when it hits 16, you move the stop up to 15.75. Surprise! The market’s rally intensifies after great earnings reports from three leading companies, and WACK runs up to 16.73 before it begins to sputter. You quickly sell out at 16.68 for a nice 13 percent profit.
If WACK had pulled back after hitting 16, you would have stopped out at 15.75 with a profit of nearly 7 percent. You could then have rebought the stock if it dropped even lower and you were still convinced that it would eventually move up again. Both scenarios rock!
What’s so special about the prices that act as support and resistance points? Is there something all the insiders know about the company’s valuation at those levels? Do they give some clue as to the real value of the company?
It’s really nothing of the sort. There’s absolutely nothing special about a number like 13 or 14.4 for WACK, or any support or resistance level for any stock. They’re more like self-fulfilling prophecies. Basically, everyone in the market, from mutual fund managers to market makers to you, is looking at the same charts. Everyone expects stocks to bounce off support because a support level is a price that is identifiable. The reason it has significance is because it is identifiable, and everyone reading the charts will identify it. Because everyone expects the stock to bounce off support, it usually will.
It really is as simple as that.
There’s no such thing as a perfect trader. If your goal is to be perfect, then trading is more about your ego than it is about making money. Every trader on the planet makes a mistake from time to time. I’ve made some whoppers, even after I got pretty good at trading. The good news is that the better you get and the more experienced you become, the fewer mistakes you’ll make. If you’re using stops on all your trades, even a few bad mistakes shouldn’t wipe you out. Instead of perfection, your goals should be to improve continually and use proper techniques and money management consistently.
While it’s in your power to prevent avoidable mistakes, you must also realize that some market events can’t be fully anticipated or planned for. Things can change very quickly—one example that comes to mind is Alan Greenspan’s surprise interest-rate cut in early January 2001, which absolutely no one saw coming. If you stay alert and nimble and have stops in place, these quick changes shouldn’t hurt you badly. But it’s always possible to be completely blindsided, to have a disastrous computer crash or other equipment outage at just the wrong time, or simply to be unable to exit a large position quickly enough. On occasion, it’s also possible to be just plain wrong about something you felt very confident about. Things can happen that aren’t your fault, and they can make you sustain a large loss.
If you ever suffer a large loss, take the following steps:
First, take some time off from trading. Just do something else for a while—ideally, a week or two. It’s healthy to have some time away from it all before you get back on the horse.
Analyze and learn from the experience. Setbacks are great learning opportunities. Take advantage of the lessons offered by the experience, and figure out how to keep the same thing from happening again.
Make necessary adjustments to your trading strategy. Figure out whether a weakness in money management or strategy contributed to the problem. Figure out how to correct the problem, and fix it.
Trade on paper or in a simulated account for a while before resuming actual trading. You need to feel comfortable and in control before you start trading your account again. You’ve been shaken emotionally, and you need to get your confidence back. Besides that, your time off from trading will have left you a little out of touch with the market when you return, and it’s better to get up to speed without risking capital. Get emotionally and intellectually comfortable by making simulated trades for a while.
Treat the experience as a thing of the past that won’t affect future trades. Don’t keep spooking yourself by reminding yourself of the disaster. The only way to trade successfully is to trade with confidence. If you’re feeling guilty or are scared of a repeat disaster, you won’t be able to trade with a winning attitude.
Treat your return to actual trading as a new start, free of pressure to regain lost capital. Whatever you do, don’t keep punishing and distracting yourself by trying to “make up for the loss.” As far as the size of your account is concerned, forget that the loss ever happened. Each day is a brand-new day. Don’t muddy your thinking by putting pressure on yourself to “undo” it.
Maintain a winning attitude and make only trades in which you have confidence. This is the attitude and approach you should always have when trading. You need to regain it and sustain it in order to continue trading.
If you take only one lesson from this whole book, let it be this one: Always, always, always use stop-loss orders on your trades. Emblazon these three words on your brain and tape them to your computer: Always use stops!
RULES OF THE GAME Always use stops!
Spend some time thinking about the following concepts. Use actual price examples as you think about them.
I. Differences Between Stop and Limit Orders
Stop orders and limit orders aren’t exact opposites of each other. Think about the differences between stop and limit orders. Commit the following points to memory:
The basic idea behind limit orders is that you don’t want to buy or sell unless you can get your price or better.
The basic idea behind stop-loss orders is that once the pain of loss has reached your trigger point, you want out right away at whatever price you’re offered.
II. Stop and Limit Order Scenarios
Work through some price examples to make sure you understand the following scenarios. Draw pictures to help you visualize the price relationships.
For long positions:
If you place a limit buy order below the current ask price, it won’t be executed until the ask reaches your limit price or better.
If you place a limit buy order above the current ask price, it will be executed immediately at the current ask because the current ask is better than your limit price.
If you place a stop sell order below the price of the stock’s last trade, it won’t be executed until someone else’s order is executed at or below your stop price.
If you place a stop sell order above the price of the stock’s last trade, it will be executed right away (unless your broker rejects it) because the current price is lower than your stop price.
For short positions:
If you place a limit sell short order above the current bid price, it won’t execute until the bid reaches your limit price or better. (You want to sell short at the highest possible price. See Chapter 10 for a full explanation of selling short.)
If you place a limit sell short order below the current bid price, it will execute immediately at the current bid because the current bid is better than your limit price.
If you place a stop buy-to-cover order above the price of the stock’s last trade, it won’t execute until the current price rises to your stop price. (You want to buy to cover at the lowest possible price. The purpose of your stop is to prevent the purchase from becoming so expensive that you lose a lot of money.)
If you place a stop buy-to-cover order below the price of the stock’s last trade, it will be executed right away (unless your broker rejects it) because the current price is higher than your stop price.
Every time you get ready to place a stop or limit order, think through exactly what will happen if the price goes up from where it is now, and what will happen if the price goes down from where it is now.