Chart Based Stops: How Not To Lose A Million Dollars

Back in the 90’s, when internet stocks were going berserk, I had a friend who was just out of law school and had decided to dabble in the markets.  He had a small account, and he decided to put it all into AOL (America Online).   As he started making the rounds to interview for a job, he noticed that his stock was taking off, moving up almost every day.

His account started to grow, and he bought more and more AOL.  His account value hit $250,000, then $500,000, and then $750,000.  It seemed as if he could do no wrong with AOL, and he had stopped interviewing with law firms, and decided that he was just going to live off the profits in his trading account.

His account continued to climb higher, and one day I asked him when he was going to take his profits, to which he replied, “When it hits one million dollars, I am going to close it out, and travel the world.”  This was a young man in his mid-twenties and one million dollars was a ton of money to him.  His account value finally hit a high of $970,000 just before the long running internet bubble began to burst.

After the first substantial decline, he told me that if it just got back to $750,000 he would sell it.  Well you know the rest of the story.  He repeated that mantra with $600,000 and $500,000 and $400,000 and so on.  He took his position all the way back down to below his original account value, and thus began knocking on doors of law firms to try to get the job he never thought he would have to get.

The takeaway from this harrowing tale is that when setting stops and targets for trading, they have to be chart based, and not money based.  The market has no idea that you exist, and thus its movements have no relation to how much you are up or down on your position.

The movements of the market are related to areas where there is support and where there is resistance; that are based upon the number of buyers and sellers in those areas.  So if your $ target on your position puts the price above resistance, you many never get that price, thus not locking in your profits.  Likewise, if your $ stop is above support, you make get taken out, just before price turns and rallies.

support-resistance2The key to converting from $ based stops or targets to chart based ones is to start by “reverse” sizing your position.  This takes away the emotional aspect of the trade, and allows you to trade better, and off of what is happening in the market, instead of what is happening in your head.  Check this post for more info on reverse position sizing.

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Brian C. Lund

Brian C. Lund

Great father. Good friend. Decent trader/writer. Lacking husband. Solid drummer. Sometimes funny. Often A-hole. Terrible poker player. Too smart. Punk rock. Work in an ice cream shop.

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