How To Place More Effective Stops

Having been on both sides of the aisle; the trader side and the brokerage side, I think I have a different perspective on the this issue of stop placement than most.  During the course of the day I see a lot of what goes on in the soft underbelly of trade executions and I also talk to a lot of traders who initiate those executions.

One of the complaints that I often hear from retail traders is, “I can’t believe it, they hit my stop and then ran the stock right back up.”  This is definitely one of the most frustrating things that can happen to a trader, and when I hear it my empathetic response is…

“No duh?   Of course they hit your stop, they knew right where it was.”

But they are not supposed to be able to see your stops right?  And if they can’t see them, then how can they go after them?

More on that in a minute.

First let me take a moment to clarify who “they” are.  To tell the truth, I don’t know who “they” are, but I watch “their” actions every day.  They could be market makers, specialists, bots, HFT’s, Algo auto-traders, a combination of all of them, or just the market mojo driven as a whole by the spirit of the late Paul Lynde.

It doesn’t really matter what the mechanics of it are, it’s just the results of those mechanics that matter.

The bottom line is that many entities in the market benefit by volume, and they do anything they can to create that volume, like triggering your stops with only a quote instead of an actual trade which I have written about before.

This type of market action has changed the rules of trading, and let’s face it, the rules of trading have always been pretty dicey to start with.

If you had a 50/50 chance of a certain trading rule holding up in past markets, it’s now more like 25/75.  Of course I am just pulling those numbers out of my ass, but you get the point; the market has changed, and you have to change the way you trade it, especially when it comes to placing stops.

Let’s start with an illustration that I painstakingly created in a very high-end program called Microsoft Paint.

In days of yore, the way this trade would have been played out is that you would have waited until a double bottom was put in at point B, entered on the bounce, and put a stop in below the red line.  If your trade did indeed fail and stop you out, it would normally continue on down to new lows.  But that’s not how it works anymore.

More often than not, before the trend completely reverses and moves back up, you get one last shiv, as price quickly drops below the double bottom to point C, and then just as quickly reverses back up above the support line and continues to run higher.  This is when I hear the retail traders start to holler about their stops being hit, run, liquidated, or “spanked” depending on what they are into.

So can they see your stops and go after them?  No they can’t, not in the sense you think they can.  In past days if a large human participant wanted to try to run the stops, well they didn’t have to be a genius to know where everybody and their brother put their stops.  Just by looking at a chart and understanding human nature they could figure that out.

Today in the world of robo-trading, “they” know the same thing, it’s just that they are programmed to know instead of having a live human being drive the strategy.

So “No!” Mr. and Mrs. retail trader, they are not running your 100, 500, or even 1000 shares of XYZ, they are running the 10’s of thousands of shares of XYZ that they know are sitting just below the double bottom of the day.  And if you are buying a breakout, it’s basically the same concept.

Price runs up, pulls back, bases, proceeds to break to new highs, but then pulls back to point C and the wehewqlkg etoetdg=reegr.g.gge;wp  %$$%()SSQds…….

Sorry my cortex just snapped from repeating myself for the millionth time.  I don’t need to belabor this point, you get what I am talking about here.

So the big question; how can I put in more effective stops?  There are basically three ways to do it, each of which I will make up a random and important sounding name for.

The Johnny Sokko And Giant Robot Method:

This involves adjusting your position size based on a “stop plus” methodology.  Normally by knowing the spread between your entry and your stop below support, you divide that into your max $ loss per trade and that is your position size.

But based on the new market dynamic you need to add a “plus” factor to your stop, in essence making your position size smaller, but giving you a better chance to not get shaken out on a run of the obvious stop level.

What you use for a plus factor depends on what type of asset class you are trading, the specific traits of the instrument in that class, and the overall market tenor.  A suggestion would be to start experimenting with a fixed percentage of the ATR and adjust depending on the results you see.

A Rainbow In Curved Air Technique:

Here you would actually anticipate the run of the stop area at point C on the above charts and put a limit buy order there.  Basically you are not buying support anymore, you are buying “support minus.”  What your minus amount is once again would need to be experimented with, but as a variation you could break your position into two or three limit buys in a range below support.

The advantage to this method is that if you do get filled below support and price does not rally back over that level, you can be reasonably sure that support has truly failed and price will continue lower making your stop out a no brainer.

The Larry Tate Experience:

The last method is a hybrid of the previous two for those that worry they will “miss a move” if they try to buy below support.  I mean what if price never gets there and they don’t get filled right?

Instead you take a half position on the bounce off of (or past) point B.  If price continues to run so be it, but if it makes a stab past support to point C, you have some dry powder to grab the second half of the position.

This ultimately gives you a better average price, and once again allows you more room for price to run back up before stopping you out, though not as much room as the “Rainbow” method.

Conclusion:

It is a common saying that trading is “chess not checkers,” but these days it is more like that 3D chess game that they had on Star Trek, with a helping of Dungeons and Dragons, and some poker thrown in.

You can no longer think in a “logical” way and have to be able to modify the traditional trading rules when it comes to stop placement and trade management.  And even more critical is the ability to think on different levels, many moves ahead, and be willing to evolve your methodology for the ever-changing market.

Brilliant stuff like this rains down like..well, rain, on my stream during the week. If you want to get wet, follow me on Twitter and StockTwits. You can also pick up my book Trading – The Best of the Best: Top Trading Tips For Our Times by clicking here.

19 Responses

  1. Pingback: Is Day Trading Really A Sucker's Game? | The bclund BlogThe bclund Blog

  2. Pingback: 5 Ways To Combat High Frequency And Algorithmic Trading - bclundbclund

  3. Another idea: adjust your platform’s equity triggers..

    TradeStation Trigger Types
    ————————————————————————
    Single Trade Tick (STT) One trade tick must print within your stop price to trigger your stop.
    Single Trade Tick within NBBO (STTN) One trade tick within the National Best Bid or Offer must print within your stop price to trigger your stop.
    Single Bid/Ask Tick (SBA) Buy/Cover Orders: One Ask tick must print within your stop price to trigger your stop.

    Sell/Short Orders: One Bid tick must print within your stop price to trigger your stop.
    Single Ask/Bid Tick (SAB) Buy/Cover Orders: One Bid tick must print within your stop price to trigger your stop.

    Sell/Short Orders: One Ask tick must print within your stop price to trigger your stop.
    Double Trade Tick (DTT) Two consecutive trade ticks must print within your stop price to trigger your stop.
    Double Trade Tick within NBBO (DTTN) Two consecutive trade ticks within the National Best Bid or Offer must print within your stop price to trigger your stop.
    Double Bid/Ask Tick (DBA) Buy/Cover Orders: Two consecutive Ask ticks must print within your stop price to trigger your stop.

    Sell/Short Orders: Two consecutive Bid ticks must print within your stop price to trigger your stop
    Double Ask/Bid Tick (DAB) Buy/Cover Orders: Two consecutive Bid ticks must print within your stop price to trigger your stop.

    Sell/Short Orders: Two consecutive Ask ticks must print within your stop price to trigger your stop.
    Twice Trade Tick (TTT) Two trade ticks must print within your stop price to trigger your stop.
    Twice Trade Tick (TTTN) Two trade ticks within the National Best Bid or Offer must print within your stop price to trigger your stop.
    Twice Bid/Ask Tick (TBA) Buy/Cover Orders: Two Ask ticks must print within your stop price to trigger your stop.

    Sell/Short Orders: Two Bid ticks must print within your stop price to trigger your stop.
    Twice Ask/Bid Tick (TAB) Buy/Cover Orders: Two Bid ticks must print within your stop price to trigger your stop.

    Sell/Short Orders: Two Ask ticks must print within your stop price to trigger your stop.

  4. ty once more!

    Don, r u setting stops incorporated into yr buy order? that’s the easiest way…in tradestation “matrix” it’s “attach OSO order”. u specify the type of stop, market or limit, then when u click to buy, it pops the stop in automatically. otherwise, u must first establish pos, then go to order bar, then type in stop price, blah blah blah by which time ur trade might be toast already. if u r a scalper anyways.

  5. Thanks for another great post.

    I’d like to read more about the mechanics of creating an exit trade. For instance, do you prepare the exit so that you can enter it quickly after the entry or have you just practiced enough that you just place the entry and then quickly create and place the exit?

    Thanks!

  6. Hey Brian, thanks for an insightful post.

    What are your thoughts on keeping stops below support (or resistance) as taught in classical technical analysis, as opposed to decreasing R for a safer stop? Especially with (only with) proper risk management, you’ll lose more trades but end up with bigger wins.

    In other words, toughen up and take the losses – if they reverse they reverse (no reason to check if your folded 2 7 offsuit hit two pair right?). Also, no reason you can’t take a loss and then get back in – as frustrating as that may be.

    • Good question. But you hit on it a bit, there is a psychological factor that comes in, at least for me. I know my tolerance for frustration in trading is short, and I don’t always have the ability to watch a position like a hawk for a re-entry. So for me it is better to take a smaller position and give it more room below the traditional support line. Also, I just see crap all day where they run those “classical” levels.

      Thanks for reading Adam.

  7. Pingback: Thursday links: multiple confusion

  8. Pingback: Pseudo Random News and Comment | Mortality Sucks

  9. Thanks for the ideas. Pretty much in line with my thinking. I wonder if you have any insight on what C is expected to be. My practice is to look for prior support/resistance, then go onto the far side of a big number (ie if support is at 15.50, set a stop at 15.49 or 15.44) . Without any technical indicators of support beyond the red line in your example, I pretty much just guess. Any thoughts? Cheers.

  10. Pingback: Thursday links: multiple confusion | Abnormal Returns

  11. Another great post with some very good ideas that you have shared. I cant speak for every trader out there but when some of the things you mentioned happen it seems like its just happening to me and I take it personally instead of learning to adapt to what is going on and accept it. Love the Blog.

    Tom

  12. Pingback: Hot Links: Most Obvious Bubble Ever | The Reformed Broker

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>