Email of the day (1)
Comment of the Day

October 22 2010

Commentary by Eoin Treacy

Email of the day (1)

on setting stops:
"Would you please review the setting of stops; other than on the MDL?"

Eoin Treacy's view Thank you for this question which others may also find of interest. Jan Bylov produced an excellent report on stops which serves as a useful preface to any discussion of the subject. It appeared in Comment of the Day on November 22nd 2007 and is no less relevant today.

The setting of stops is a topic which seems to attract perpetual debate primarily because it is so subjective. How we approach the subject will depend entirely on our individual circumstances but the size of one's position and how much of a drawdown is tolerable will always be part of the equation. While the setting of stops is somewhat subjective, there are a number of useful attitudes to adopt which can aid in the process. .

It is never time misspent to think about where one will come out of a position before actually putting the trade on in the first place. If we get the sequencing right, i.e. thinking about what might go wrong, before putting capital to work, there is a stronger likelihood we will also tailor the position size to suit the given circumstances. The alternative is set the stop to suit the position size which is far from ideal.

I believe it is a valid question as to whether stops are warranted in all circumstances. Well defined base formation development is where the greatest perception of risk is evident among the horde of investors expressing antipathy towards the market. However, base formations actually represent the least risky area for potential investors since the vast majority of the decline has already occurred. Base formations are volatile, so if one considers a stop it should be to protect against the eventuality that the downtrend is reasserted. It would need to be wide enough to ensure that one is not whipped out as a result of the volatility that can be expected in a developing base.

The perception of risk is always lowest following impressive multi-year advances and investor's money control discipline is usually fairly lax. However, this is when stops are most appropriate because one has a profit to protect and the risk that one is approaching a meaningful top area is much greater than at the bottom.

One should always think about why you are setting a stop. Is it to protect against an unacceptably large loss, to make sure you breakeven or to minimize profit erosion? When we have delineated our aims, we are in a much better position to judge whether the circumstances provided by the market marry up with our ambitions for the trade.

Stops are subjective because we all have different ambitions, risk tolerances and because no two trends are the same. Therefore it is imperative that we identify facts about the price action rather than allow our impressions and expectations to assume the guise of analysis. The consistency characteristics method of getting to know a trend that we teach at The Chart Seminar is a direct route to greater knowledge of the interaction between supply and demand.

Filter questions such as:

Is it trending or ranging?
If it is trending is it consistent or inconsistent?
If it is consistent, what are the consistency characteristics?

Examples in an uptrend might include:

Progressions of higher reaction lows,
Progressions of higher rally highs
Reactions one above another
Similar sized reactions,
Similar sized advances
Length of time spent ranging
Relative strength.

A consistent trend is a trend in motion. Once we know what the consistency characteristics are, provided they remain intact, it is reasonable to assume that the situation will continue. For example, if an instrument has been trending higher with reactions of no more than five units of scale then it is reasonable to place a six unit sell stop, so that one will be taken out in the event of a larger reaction but will stay in if the trend remains consistent.

No discussion of stops can be isolated from considering money control discipline. In powerfully trending markets, the temptation to bunch trades around a given price level, in the expectation of a significant extension of the uptrend, is high. The resulting higher average purchase price means that a breakeven stop might be tighter than could be justified by the consistency characteristics evident in the price action. Tailoring the position size to the consistency characteristics makes placing the stop a much simpler endeavour. .

When a trend moves into a rapidly accelerating advance then a trailing stop is warranted in order to protect profits but this should equally be based on the consistency of the wider trend. One can ascertain what a 'normal' reaction looks like from the price chart and a review of the consistency characteristics. Placing a trailing stop of slightly larger than a 'normal' reaction will make sure one will only exit in the every of a major trend inconsistency such as a larger reaction.

Occasionally one might be stopped out of what has been a consistent trend by a slightly larger reaction or some intraday volatility, only for the market to rally back and breakout to new high ground. The temptation to buy the position back and abandon money control discipline is high because the strategy has been seen to be faulty and prices are advancing this time without us.

Trends often lose their consistency at the penultimate high so if consistency is deteriorating it is a signal that the relationship between supply and demand is changing. One might still conclude that the risk is worth it, but the safer approach would be to begin rebuilding the position from scratch rather than buying back the full allocation in one go and accepting the resulting high average purchase price.

For those interested in the Midpoint Danger Line (MDL) stop we teach at The Chart Seminar, David highlighted a discussion of the method in Comment of the Day on August 13th when he posted the historic FM6 from August 1984.

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