Option Investor
Trader's Corner

Where's My Stop?

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Once when boarding a train from Madrid, Spain, my whole family in tow, I questioned fellow passengers about the stop for Toledo. I didn't see it listed on the route posted overhead, and I was the only one who spoke Spanish. It turned out we had boarded the wrong train. It wasn't going to Toledo at all.

Sometimes traders find themselves in the same spot. They've entered a trade, thinking it's going one direction, only to find out it's headed somewhere else entirely. I was lucky in Spain. We had barely pulled out of the Atocha station before I found out that the train was going the wrong direction. We were able to get off one station away and board the correct train. Traders need to find out quickly when they're going the wrong direction, too, so they can get off the train before it travels too far. Traders need stops.

Setting stops proves relatively easy in a trending market. Trending markets tend to come back to key moving averages or an established trendline, bouncing from them. In a down-trending market, set a stop just above such a key average or a descending trendline.

BAC was such a down-trending stock. In late June, it had violated its 30-sma. By early July, it had risen to retest that average, finding resistance again. Then it gapped lower after that failed test, signaling that a bearish entry might be good idea, perhaps offering an entry just above $45.00.

Note: Charts were chosen to illustrate when stops might be taken, and do not represent current values.

Annotated Daily Chart of BAC:

What happened next? September 16, the last day on this chart, was notable for including a re-weighting of the SPX, equity option expiration, and a presidential speech the previous night. That speech had all debating the costs of rebuilding Louisiana and Mississippi, and the effect on taxes and interest rates. BAC's action that Friday might have been a fluke, some might have reasoned, and price was approaching potential resistance at $44.00 by the close. In a recent SFO Magazine article, the great Thomas N. Bulkowski explained his attitude after selling a stock that had violated a trendline, and the opposite might be inferred, too. "Even if I am wrong," about selling the stock after it violates a trendline, he said, "it doesn't matter, because I don't own the stock anymore." Presumably he feels the same about covering a short when a stop has been hit.

As it turned out, September 16 did turn out to be a fluke, and BAC ended the current week at $42.23, but take a lesson from Bulkowski. Adhere to your trading plan, exit when your stop is hit, and don't look back. Certainly don't ignore a stop because you "think" or "hope" prices will turn around again. In BAC's case, the bearish trader would have profited more if that trader had held on, but in other cases, the outcome would not have been so good.

In a trending market, some traders also position stops just below a previous swing high on an up-trending market and just above a previous swing low on a down-trending one. If breakaway gaps--those that occur when price gaps out of a consolidation pattern--exist, stops can be set below an upside gap and above a downside one.

Annotated 240-Minute Chart of TXN:

Markets don't always trend upward or downward, of course. Range-bound markets sometimes offer trades of the "buy low, sell high" variety once a range has been established. Horizontal trendlines can often be drawn, with a favorite oscillator then used to choose entries. Longs can switch to shorts as the top boundary is approached and then switch back to longs as the bottom boundary is approached. Stops could be set an account appropriate level either side of the range.

Annotated Weekly Chart of DD:

Bulkowski offers another bit of advice about setting those stops. Avoid round numbers, he cautions. He would likely also caution against using a number such as $39.75, instead using "oddball" numbers for stops. Oddball numbers might prove less likely to be touched in stop-running moves. Jane Fox of OptionInvestor also sometimes advices that traders use contingent orders, with the order held with the broker until the contingency is met. This avoids giving market makers a view of your stop, avoiding a little stop-running move to pick it off before a reversal again.

Bulkowski's discussion in SFO Magazine offers his experiences trading stocks, but those traders who utilize options have special considerations. An options trader must be right on both direction and timing. A stock or index might creep higher while a call's value inches lower because the creeping stock movement proves too slow. This effect intensifies in the last two weeks of an options cycle before expiration. How does an options trader set appropriate stops if timing must also be considered?

Traders adopt several approaches. When I first began trading, I remember an options trader mentioning that if an option had lost one-third of its value, the play was probably not working as expected. Setting a stop contingent upon either the option's value or the stock's appear equally valid. Some trading platforms even allow for the setting of two conditions in a contingency order, with a one-cancels-other possibility. An OEX put's stop might be conditioned on the OEX staying below a certain number and its option staying above a certain value, for example. If your trading style incorporates decay in an option's value when setting a stop, perhaps search for a trading platform that allows for two conditions when setting stops.

Not all traders base their stops upon the option's decay. Some traders, including the OIN's Jeff Bailey, have at times employed a different strategy. That strategy involves deciding the amount of risk or size of loss a trader is willing to accept on a stock play, then purchasing an option position for that amount. No stop would be set, because no more than the predetermined risk or loss will be incurred.

By this point, it's clear that a trader's style and the condition of the markets must be considered when setting stops. Back in Spain, I acted conservatively, getting off at the first stop encountered after entry, and that's the type of trader I tend to be, too. Perhaps there would have been another train that intersected with ours and gotten us to Toledo faster, but I never worried about that after getting off the wrong train and boarding one that was going to bring us to Toledo. Bulkowski recommends not looking back, either. Set those stops and get off as soon as you find that the train is not going the direction you intended.
 

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