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Stop Loss
The Smart Profits Report: Issue #332
Thursday, July 20, 2006
Stop Loss: Three Reasons to Get Out of a Trade Before it Hits Your Trailing Stop
By D.R. Barton, Jr.
Advisory Panelist, Mt. Vernon Research
You just bought some options (or a stock, or a futures contract, etc.). You then place your stop loss with tender loving care - exactly where it should be, according to your plan. The stop loss is far enough away to avoid the normal fluctuations of the market and close enough to give you a good reward-to-risk ratio if things move in your direction.
And then it happens - a big move against your position. Within hours, you’re already 75% of the way to being stopped out. Ouch. I’m sure you’ve been there before. I know I have.
So what do you do now? Bail out? Stay the course? Kick the dog, or yell at the cat? Blame those stinkin’ floor traders? There’s a better way to handle this situation. Many investors have learned to stand pat and wait for the investment to hit the stop loss. This is often the best option for many trading strategies - for example, technical styles and value investing.
But there are times when prudent traders and investors will want get out of a position before their stop losses are hit. So let’s take a look at some reasons why you might want to consider adding an “early exit” contingency to your trading or investing plan.
When to Head for an Early Exit
When you place a proper stop loss in the right place according to your trading plan, in the majority of cases, you should stay in the trade until you hit your stop loss or your trading plan tells you to get out for some other reason. Bailing out on a whim, or at the first little move against you, can be frustrating - and ultimately expensive.
You place stop losses (trailing stops) for a reason: to protect your capital, while giving your investment sufficient room to work and grow. But there are instances when you may need to build a “contingency” plan into your trading strategy.
Our guiding principle for early exits is this: When the reason you got into your trade changes significantly, prepare to get out.
Here are three situations that you may want to add to your trading plan:
- Technical Changes
- Geopolitical or Other External Events
- Time Factor and a Stagnant Investment
Keep reading for explanations of all three of these situations that may lead to an early exit.
Your Three-Step Early Exit System
Technical Change: Traders often make a trade because of a technical signal that told them to enter. After a period of time, while the security hasn’t hit your stop loss, that technical signal goes neutral or reverses and points in the other direction. Many systems do not take this change into account and simply wait for the stop to be hit. But if the reason you got in no longer exists, it’s probably time to get out.
Example: Your system is trading a simple long-term trend. When the fast moving average crosses above the slow one, you get an entry signal and buy. Let’s say a week passes and the fast moving average then dives below the slow one and heads down. If your system doesn’t recognize this as an exit, you could still be in the trade, waiting for it to hit your stop loss - even though your indictor is now clearly pointing the other direction.
Geopolitical or Other External Events: Often, major external factors strike markets, including the weather, armed conflicts or governmental actions. Such activities can signal significant changes that have wide-reaching effects on markets. It’s like building sandcastles in front of a storm surge - no matter how good your design, your project on the beach is going to get wiped out.
Example: This happened just last week, when I suggested that oil is destined to go lower in the short- to intermediate-term. But then, Israel and Hezbollah started an armed conflict just days later - and oil prices predictably saw a temporary spike. Good technical and sentiment analysis will always be trumped by big news in the short term. Unless the fighting in the Middle East escalates beyond the Hezbollah in southern Lebanon, we’ve already seen the highest oil prices for now and they will decline from here. As I stated in last week’s piece, if this escalates, or other oil-related upsets occur, all bets are off and you should re-evaluate your positions.
Time Factor and a Stagnant Investment: Most successful short-term traders also include a time component in their trading plan - especially when it comes to waiting for a position to move in their favor. If a short-term trader enters a position expecting a move and it doesn’t materialize in a certain amount of time, then a time stop is used and the position is exited.
The reasoning is this: If all the “buy” factors were lined up strongly and nothing happened, you’ve either lost the advantage and are staring at a 50/50 proposition, or the opportunity wasn’t as strong as expected. Either way, it’s best to get out and re-evaluate the situation without the influences and biases that an active position imposes.
This same reasoning is useful for longer-term traders and investors, as well. If you purchase a stock because the new management team is supposed to turn things around, or because of the benefits of a new product line, and the share price goes nowhere after months (or years), then it’s time to reassess the investment.
Your Well-Designed Investment Plan Needs Stop Losses
Stops are part of every well-designed investing plan. But be aware that there may be situations that arise when an early exit strategy is better. Do some pre-planning for situations that might arise, and build appropriate responses and contingency plans into your investment strategy.
Good Trading,
D.R. Barton
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Today’s Smart Profits Cribsheet
- Deciding when to pull the trigger on an investment and sell is one of the most difficult - but very necessary - decisions an investor needs to make. Check out Smart Profits #133, Trailing Stops: How to Give Your Options Room to Grow - and take the emotion out of the situation by employing a stop loss policy.
- I talked here about how external factors such as geopolitical issues and military conflicts can have an impact on your portfolio and stop loss policy. It’s something that affects all investors, so if you’re worried and wondering how to protect yourself, follow my simple “global guideline” in Smart Profits #320, What’s Happening in the Global Markets: The Global “Ripple’s” Headed Our Way.
Related Articles
- Exit Strategies: Prenuptial Agreements for Options
- Time Stops Strategy: Your 10-Day Profit Test
- Portfolio Position Sizing: The “10% Rule” for Safe Option Profits
The Chart of the Week
Broadcom (Nasdaq: BRCM) has had a monster selloff since February, losing almost 50% of its value. However, it has hit strong support at its gap from July 2005. The stock is currently consolidating and has been for over a week. If it cannot close below $26.50 in the next five to 10 days, expect a bounce. A close below this key level spells more trouble for this stock with $18.25 as the next strong support zone.
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