At the risk of stating the obvious, entering and exiting a position is the hardest part of trading. There is always a constant struggle between taking small losses, taking small profits, and letting your profits run in the hope of taking big profits. Ok, time to put the kids to bed, turn down the TV, kick back in the recliner, and fasten your seatbelt because this is going to change the way you trade.
By now you should have a good feel for what support and resistance is, how it is created and destroyed, and hopefully a fairly good understanding of how to spot it. If not, don’t worry, this will come with practice. First, I would like to go over some basic rules and then we’ll talk about the challenges of entering a position long and short, and finally we’ll talk about getting you out of a position at the right time, hopefully with a profit.
Ten Simple Rules
I’d like to discuss some simple rules for trading stocks and then we’ll look at a few charts. In the interest of time, and space the list is drafted assuming you are long. Just reverse the scenario if you are short.
1. Enter your long position when it breaks out above resistance and look for strong volume to confirm the move. Strong volume is not necessary for shorts, as we will see a little later.
2. Start with an arbitrary stop of -10%. I say this for two reasons. First, it is easy to calculate, and, second, I’m never willing to take a loss over 10%. You also need to be aware that a stock can easily drop 10% in one day so adjust your level of risk accordingly if you have a difficult time shrugging off 10%.
3. Now that you have your arbitrary stop, look at the chart. Do you see a recent bottom that is close to your 10% stop? Yes? Place it there. This is very important because it is very common for stocks to trade down in the A.M., following a nice move up on the previous day.
4. If the stock immediately moves in the direction you want, you need to begin tightening your stop but at a slower rate than the stock is moving – again, not exactly under todays bottom. If you do this you are risking getting stopped out at the open only to find your stock go higher later in the day. I’ve found that, in the early part of a trade and, as a general rule, you want to stay approximately 1 ½ days behind the most recent lows. For example, on a percent-wise basis, you buy a break out and find your stock has moved 6% higher than where you purchased it. You want to move your stop up about 3%.
5. You are sitting on a nice profit and your stock is approaching your target. What do you do? If the stock trades through your target on an intra-day basis ONLY, let it run. Don’t get in the way of more profits. Targets are just an aid. If there was ever a part of trading that is more art than science this is it, especially if your target doesn’t coincide with a recent high. For example, it’s Monday morning and your stock is just under your target of 20.00. A surge of buyers step in and push your stock to 21.00. Do you sell it at 20.00? No, let it keep going as far as it wants to. If it turns around and starts trading below 20.00 you simply sell. If it keeps going to 30.00 you just sit back and enjoy the ride – don’t get in the way of more profits.
6. You find yourself in a stock that is beyond its target. What do you do? Give it every opportunity to keep going, but don’t get greedy. Stocks rarely go past their targets without taking a break. Get ready to aggressively take profits.
7. You find yourself in a profitable stock that hasn’t hit its target and it starts to pull back. This is the toughest part. Do you take profits or let it retest the break out point? I can show many more charts that retest than I can that don’t. This is a very common occurrence. There is no simple answer to this but… if the markets are overbought you don’t want to let your stock move much against you. If the markets are oversold and beginning to turn up then you can let it pull back and give it a chance to resume its march higher toward the target. Again, this is the toughest part. Getting good at this comes mostly with experience.
8. You find yourself in a stock and it begins to move against you almost immediately. What do you do? This is the secret to successful trading. Strong stocks don’t break out and pull right back. You have to realize that it is normal for a stock to pull back after a nice move past the break out point, but it is not normal for a stock to break out and immediately fall. You want to be very careful here. Start moving your stops up at a faster rate than you would if you were in a profitable trade. Try to tolerate at least one day against you provided it doesn’t exceed your risk tolerance. If the stock goes green the next day then you are back to zero days against you. If you get two consecutive down days you should be taking your loss, depending on how much the stock dropped. If you’re down say, 6%, you’re out. If you’re down 2% you should still give it a chance.
9. You find that you have purchased a stock that has broken out on low volume. You don’t want to immediately sell it. Give it a chance, volume can show up. Be cautious, but give it a chance.
10. Rules are made to be broken. This list is just an aid and depends on where the major markets are. Overbought – be cautious with longs. Oversold – be cautious with shorts. Don’t expect to trade with 10 basic rules and expect to be an excellent trader. Just use these rules as an aid and learn from experience. Again, these rules don’t work all the time. Market conditions change constantly and you have to change with them.
The Challenges of Going Long
There is one big challenge with going long on a break out – it’s volume. You want volume to be as big as possible because it takes a lot of interest and enthusiasm about a stock to push it to new highs. So, how do you know if volume is going to be high or not? Here are two things you can look for. First, you need to know what the average daily volume and previous day’s volume is. Second, there are 6 ½ trading hours in the day. Now, take the average daily volume and divide it by 6.5.
This gives you “average” volume per hour. I highlighted average for a reason. A large portion of a stock’s daily volume occurs in the first hour of trading. So, do you want to see 1-hour’s worth of volume go by the board in the first hour? Of course not, you want much more. As a general rule, I look for twice the average hourly volume in the first hour. Of course, it is even better if 3 or 4 times average volume shows up in the first hour – the more the better. You want volume to be massive! This will put you on target to surpass the average daily volume, and hopefully the previous day’s volume.
Now that you know what you’re looking for, I will give you an aid on how to spot it before it actually occurs. Most tradable stocks trade on either the New York Stock Exchange (NYSE), or the National Association of Securities Dealers Automated Quotation System (NASDAQ). In case you don’t know which is which, NASDAQ stocks trade with four symbols such as ABCD, while NYSE stocks trade with three such as ABC. There are a few exceptions to this rule. Some stocks trade with 5 symbols. It is very important to make this distinction because the two types of stocks trade differently before the market opens.
NASDAQ stocks can, and do trade before the market opens if there is a lot of interest in buying or selling the stock. If the same thing occurs on listed stocks (NYSE), trading is usually delayed at the open to give the specialist an opportunity to match the imbalance between buyers and sellers. So, how do you use this to your advantage? For NASDAQ stocks the answer is simple. You will see volume picking up on your order screen, or your quotation screen. It should be located somewhere on the platform that you place your trade on. Picture this scenario, the futures are up, the stock is up in pre-market on solid volume and the equity markets open up. That is an ideal time to buy the break out, provided it doesn’t open with a huge gap up. Keep in mind, however, NASDAQ stocks often wait until the bell rings before they take off, even if volume turns out to be huge.
What about listed stocks? These stocks don’t usually trade before the open. So, if the bell rings and the stock you’re watching shows zero shares traded for an extended period of time it is a clue that something good may be about to happen. There may be an order imbalance in favor of buying and you should be getting excited about the possibilities. Again, this is just an aid, I’ve seen stocks delayed at the open only to open flat, but this is something to watch. Ok, let’s hit the charts.
When to go long, timing is everything
Let’s talk about the chart of BLS. I put this chart first on the list because I want to make sure you remember it. If you traded this stock the way I describe you would be able to put it in a frame and label it, “my best trade of the year.” BLS bottomed in October of 2002 at 18.32. It promptly rallied 57% and began consolidating until early January of 2003. It was consolidating in a nice ascending triangle pattern, which ended with a break out above its recent high, and on strong volume.
Everything was lined up just perfectly. Right about now you should be thinking profit. Let’s go through the steps. You trade your stock according to your system, which means you bought the stock just above 28.70. You set an arbitrary stop at 10%, which puts you at 25.83. That puts you right under the most recent low in the ascending triangle. After the market closes you move your stop up to the bottom of the previous day’s close – this is approximately 27.00. Worst case, you’re out with a 6% loss. Now let’s move onto the next chart.
On the chart above BLS opened at 28.45, which is below the break out price. Later in the day it rallied to close above the initial break out price, but still down for the day. Now, I want you to ask yourself…. Did it hit your stop? No, it didn’t so you should still be in this. On an intra-day basis this stock looks ugly. On a daily basis it doesn’t look bad at all. However, the fact that it opened much lower than your purchase price is a reason for concern. Now it is time to adjust your stop. Do you place it right below today’s low? Remember, if you do you risk the possibility of getting stopped out at the open only to find your stock move higher later on in the day. A good place for your stop would be just under the break out candle. That puts you at approximately 27.75. Ok, on to the next chart.
If you look at the chart above you will see that BLS opened lower again, except this time it wasn’t bought like the previous day. This time it kept on falling and almost closed on the low of the day. This is the second day against you and you are out with a loss of just over 3%. Let’s see how this story ends.
Not only did BLS trade below 27.75, it traded below the lower boundary of the ascending triangle. In fact, it traded as low as 19.79 before it recovered. That represents a 31% loss. How much did you lose? You lost 3% – a difference of 28%. There is a right way to lose money and a wrong way to lose money. This is the right way; selling at 20 bucks is the wrong way. ALWAYS use stops. Don’t take big losses. This is the single most important thing you need to work on – always use stops, don’t take big losses.
This stock was a picture perfect break out that had profit written all over it. Instead it fell apart. From this day forward I want you to promise yourself you will always use stops and you will never take big losses. There is no exception to this rule. The next time you have a trade like this you can put it in a frame and label it, “My best trade of the year!”
Let’s move on to the next stock. I want you to look at the chart of AAI above at the point labeled “Here.” Does this look like a strong stock or a weak stock? Of course, it’s a strong stock – buy strength, sell weakness – remember that. AAI began turning into a strong stock when it traded above the recent high of 4.04. Was this a time to go long?
No, and I’ll tell you why in just a minute. There are two times you want to start buying – at the end of a bottom reversal pattern, or at the end of a continuation pattern in an up trend. Look again at the chart. Do you see either pattern occurring between June and October 2002? Study it for a second and move on to the next chart.
Did you see this? Remember I asked you if the “here” label on the first chart of AAI represented a point to buy? If you examine the first chart of AAI you will notice there is a huge gap between the point it traded to a new high and the points on the left side of resistance (blue line). Look at the chart directly above. Those points of resistance are much closer together and represent a much better consolidation and break out pattern. If you look closely you will notice that the pattern on the chart directly above is almost the mirror image of the first chart of AAI, except that it occurs at a slightly higher price. This is a reversal pattern. A bottom was put in and not long after the stock made a higher low. This is bullish.
Now I want to draw your attention to point 1. The stock actually broke out on decent volume (point 2). Was this a solid break out? Volume was strong and above average but not incredibly impressive. That in-of-itself is not a reason for concern. Now look at the price. How did the stock finish the day? It closed below resistance. This coupled with the fact that volume wasn’t all that impressive is a reason for concern. So, do you sell the stock immediately? Of course not, you always give it a chance.
The following day the stock closed down so you begin tightening stops. The ideal place would be slightly under the candle on the break out day. The next day your stop would have been hit and you would have been out with a small loss. By this point you’re probably not feeling very bullish about AAI. So, do you give up on it and move on to the next stock? Two days later it is on the move again. What do you do? It is not uncommon to have to trade a stock more than once to make a profit on it. The fact that you lost money the first time doesn’t make this a bad stock to play. Look what happened three days after you took your small loss.
If you look at the chart above you will see something that is fairly similar to the situation you just found yourself in. There is one difference… what is it? Exactly, the stock closed above resistance. Still, the volume wasn’t impressive but does that mean you get ready to dump your stock? No, of course not because… volume can show up after the break out.
Ahh, volume finally shows up. AAI gaps up the next day and just falls shy of hitting the target on the fourth day. Targets are a lesson for another day, so just go with the flow here. Finally, we’re in a stock with a profit. Now it gets tougher. You’re in a stock that is making you money. There are a ton of thoughts and feelings going through your mind right about now. Do I sell, do I hold, what do I do? Look at the candle on the day the stock almost hit the first target of 5.50. You have to be very cautious when stocks gap up after a solid run. They usually get sold by profit takers and short sellers. You would not have been mistaken to take at least ½ profits on this day.
You should remember from “Support and Resistance Explained” that stocks often times retest the initial break out point. AAI did just that. It didn’t quite make it back to 4.50 so this is even more of a reason to remain bullish. Sure enough, about a week later AAI took off on massive volume. This stock took off like an absolute rocket and you’re still in it, right? If you said no don’t feel bad, because this is the toughest part of the game. I want you to notice two things as the stock approaches the second target.
Look at the massive volume. It continued like that for four consecutive days. This is referred to as a “blow off top.” Buyers get exhausted in a massive four-day buying spree. There is simply no way this can continue. AAI came just shy of the second target on the last huge up day. You should be completely out on this day.
At the very latest, you should be out on the next day with the 6.79 label. Stocks don’t go up forever and as a trader, when a stock hits its second target and stops rising you take profits relentlessly. The only thing that separated this trade from the first one was timing. The timing on the first trade was off by just a few days. Don’t give up on a stock just because you had to take a small loss the first time around. This is how to trade like a professional. How are we doing? Are you feeling a change coming along? Good, next trade.
Oh, you didn’t think we were finished with AAI did you? Stocks often give you opportunities to play them two or three times along the way. There is actually a triangle pattern connecting the 6.79 high and the 5.29 low, so see if you can find that on your own.
During the April – June period you will see a continuation pattern with resistance at 8.00 and a target of 10.00. We can go through this one very quickly. AAI broke out on huge volume and closed well above the break out point. You should have entered this stock just above 8.00 and since it made such a solid move it would be safe to set your stops just under today’s low. The next down day was expected, considering such a violent move on the first day. You tolerate one day against you and begin tightening stops.
So, you’re still in this, right? Good. The third day was really a non-event day. It would not be a bad idea to tighten stops a little more here. The fourth day was a bullish hammer – we’ll do candles another day. On the fifth day you will notice the stock gapped up at the open, stopped just shy of hitting the target, and immediately fell. Do you take profits on that day? The answer is a resounding YES! But why? First, the stock gapped up and fell.
That is not bullish. Second, the target was almost hit. Remember, targets are not an exact science. Finally, at this time the markets were extremely overbought so you simply take your profits and head straight to the bank. I have one more example and then we will move on to going short.
Look at the chart above of PLMD. It rallied at the end of April on huge volume and began consolidating in an ascending triangle for about 6-weeks. It looked like it was ready to make its next move. You will notice that it broke out of this pattern on the last two days on the chart. Look at the volume, what do you see? Yes, it is very low. In fact, it is lower on the second day than it is on the first. The price also closed below the break out point on both days. This has false break out written all over it.
You would have been justified in buying as soon as PLMD broke out – even on low volume, but now what do you do? Do you just flat out sell it? No! Do you move your stops up to protect losses? Yes! Do you place your stop right below the last days low? No way! The stock hasn’t even had one down day yet. This is not what a good break out looks like so you have to be cautious, but you don’t just flat out sell it. Scroll down to the next chart.
Now aren’t you glad you didn’t sell it? Volume was very strong on the days following the break out. Look at the target. Did it get hit on the second huge up day? Yes, in fact, it surpassed it on an intra-day basis. Remember what I said in Rule 5 about targets getting blown by on an intra-day basis. Here you have it. Instead of selling at 43 you’re sitting on a stock that is worth nearly 44. From here it is all icing on the cake and you can freely sell at any time. The next day the stock opened up and sold off intra-day. This was an ideal time to exit. You should walk away from this somewhere around 44. Nice trade.
The Challenges of Going Short
There is a common misconception that selling a stock short is extremely risky because the stock can go to infinity and your potential loss is unlimited, and, furthermore, your potential gain is limited because the stock can only go down as far as zero. Let’s start off by putting these two misconceptions to rest. First, if you bought a stock you would use a stop to protect against large losses, right? So, wouldn’t you do the same with a short sell? Of course you would. What about the stock going to zero?
Let’s say you shorted a stock at 100 and it falls to 80. You need a margin enabled account to sell short, and whenever your position begins to show a profit your “buying power” increases. So, why don’t you take your additional buying power and keep shorting the stock until it goes to zero. Of course, this is only to prove a point. I don’t practice this strategy, nor do I recommend it. A short sell does not come with unlimited risk, nor does it come with a limited gain.
In order to short sell a stock you need an “up-tick” or a “zero plus-tick.” An up-tick simply means the current price has to be greater than the previous price. A zero plus-tick means two trades can go by on the same price provided it originated from an up-tick. For example, one trade occurs at 49.05. Then next occurs at 49.06 – this is an up-tick and you can short this. The third one occurs at 49.06 again, and, likewise, you can short this – this is a zero plus-tick. You cannot short a stock that trades in the fashion of – 49.05, 49.04, 49.00, 48.85, and so on. The price has to tick up at some point. It is very easy to miss a trade because of this.
Here is a strategy I employ in an effort to overcome this hurdle. I am not very fond of market orders because they leave you exposed, especially on a thinly traded stock. So, let’s say you want to short a stock when it breaks support at 20.00. I place a sell limit at approximately 19.90, which gives me the chance to sell short at 19.90 or “better.” This way, your order is a 19.90 limit order with a market order attached for anything above 19.90. You can get hit from 19.90 or “better.”
You have to be careful with this kind of order because the “better” clause also includes prices higher than 20.00. There is a way around this too. You can place a sell short stop limit. It would read something like this: sell stop 20.00, limit 19.90, which means your order will be activated when your stock trades through and below 20.00. Your order then becomes a market order but with a boundary between 20.00 and 19.90. Your exposure is limited to 10 cents.
When to go short, timing is everything
Look above at the chart of CGNX. This is a picture perfect short with well-defined support at the 13.75 area. The time to short this stock is precisely when it breaks support at that level. Your ideal entry would have been 13.74. Now look closely at where the stock finished the day. Exactly, above support. Remember we said we wanted a break out to finish the day above resistance? The same applies to going short except you want your stock to finish the day below support. This is a reason to be concerned but not a reason to just cover your short. Look at the volume. Is it small, average, big… what is it? Right, it is slightly below average.
Now, do we want massive volume on a break down? Remember, stocks can fall just from the lack of buying and you actually want volume to be about average. You don’t want sellers to be exhausted all at once. You want most of the selling to occur at the bottom… right where you will cover your short. Now, where do you place your stop? A 10% loss brings you in at 15.12. So, you look at the chart and look for something in the area of 15.12. The closest stop in that area is about 15.60.
That is too high so you need to pick a place that is closer to 15.12. A good starting point here would be a notch above 15.00, perhaps 15.01. After the trading day you go back and see how your stock finished. It’s above support so what do you do? Exactly, you begin to tighten your stop but you do not place it directly on top of the current day’s high.
Now look at the chart above. What would have happened had you placed your stop right on the high of the previous day? Right, you would have been stopped out only to see your stock fall later on in the day. You do need to be concerned that CGNX did trade higher than the high of the previous day even though it closed lower. Let’s move on to the next chart.
Look at the chart above. Today, CGNX closed the day up but on light volume. Is this a reason to be concerned? Your initial answer may be no because it rallied on low volume and didn’t take out the previous day’s high. You would be correct in your observation but you need to take a closer look. What do you see? Just look at the price action. The stock opened lower than support and traded as low as 13.01. What happened from there? It rallied violently from the low of 13.01 to a high of 14.55 – that’s 11.8% from the bottom, and almost 6% higher than your entry point.
This stock was moving in one direction…UP! The correct thing to do here was to cover your short on anything over 13.74 – the reason is based on major market analysis, which is a lesson for another day. Suffice it to say, the major markets were oversold in an incredible way. Look at the month on the chart. As it turned out, October was exactly when the market bottomed. We’ll discuss this at another time but this is something you need to be aware of now.
Take one last look at CGNX on the chart above. Had you traded this without a stop you would have lost a bundle. The very next day the stock gapped up and didn’t look back until it hit $20. Worst case, if you didn’t close your position on the day it rallied from 13.01 you should have closed in on the next day that it gapped up. You would have lost about 6% on your trade, but that’s a lot less painful than covering at $20, which would represent a loss of approximately 46%. There is a right way to lose money and a wrong way to lose money. Losing 6% is the right way; losing 46% is the wrong way.
Now let’s look at the chart of AOL. At the point labeled “Here,” is this a strong stock or a weak stock? Correct, a weak stock – buy strength, sell weakness. You remember that right? AOL turned into a weak stock when it traded below the support level identified by the blue line. In fact, this could have been a good place to short the stock. You could have covered your short in the low-to-mid-40s for a solid profit. Let’s move on a little further to see if AOL gives us another chance to short it.
Sure enough, AOL was trading in a neutral to bearish pattern and sitting right on support, looking ripe to be shorted if and when it broke down.
On the chart above, you will see that AOL did, in fact, break support. The only problem is…what? Correct, it ended the day above resistance, and on strong volume. This is a real reason to be concerned. Let’s go through the scenario. AOL trades below 31 so it has broken support and is a good short candidate. You open your short just under 31 and you approximate your 10% loss, which puts you at 34.10. You look at the chart and you see that the last high occurred at approximately 33.50 and you place your stop right above that.
At the end of your day you open your online trading account to find that AOL has finished the day positive and on strong volume. You do the prudent thing and you begin to tighten your stops. There are two things here that tell you this stock is going to rally – price and volume. So, you place your stop just above the high of the day and wait until tomorrow to see if AOL can resume its march downhill.
The next morning you wake up to find that AOL is about to rally. You aren’t very concerned because your stop is in place and your loss is locked in. Sure enough, AOL does rally and you’re out of it with a 5-6% loss. Right about now you probably aren’t feeling very bearish about AOL anymore. So, you take your loss and move on to the next stock, right? Well, maybe, but remember timing is everything and AOL may give you another chance. Let’s see how this story ends.
If you look at the chart above you will see that AOL broke support three days later. The stock did close slightly higher than it opened, but still down for the day. Your approximate entry point would have been about 31 again. You calculate your arbitrary 10% loss, you look at the chart for a point that is close to that and you place your stop just above 33.00.
Now you will see that AOL dropped for two consecutive days following your initial short entry point. At this point you begin to tighten your stops at a slower pace than the stock is moving – i.e. let it run. Not long after, AOL began to make the march right toward the target of 25. The closer the stock gets to the target the tighter your stops get. Now look at the day that the stock traded below 25 for the first time – it’s the day that is four days to the left of the 23.60 label. What happened? The stock traded right through your target on an intra-day basis. Right here you give it every chance to run further.
Unfortunately, AOL reversed course and closed the day higher than 25 and… you’re out. No questions asked… you are out!! Look at the volume on this day…what do you see? It’s pretty massive isn’t it? That is a capitulation sell-off and a clue that all sellers are getting exhausted. AOL actually went on to make a low of 23.60 before it rallied but no one can ever expect to trade at the exact tops or bottoms of the market – and I mean no one!! This is how you trade like a professional – slow, methodical, mechanical, and disciplined. Your first trade resulted in an approximate 6% loss; your second was an approximate 19% gain. That is a positive cash flow!
Let’s go through one more chart and then we’ll wrap things up. My favorite pattern on the short side is the head and shoulders top. Look at the chart of OII above. Look closely at the volume on each section of the pattern. You should see strong volume on the left shoulder, higher volume on the head, and pathetic volume on the right shoulder. If there was ever a chart that is screaming “short me” this is it. Sure enough, OII broke support when it traded under 25.60. It closed down for the day on light selling volume – remember light selling volume on a break down is actually good. Your arbitrary 10% stop is at 28.14, assuming you opened your position just below 25.60. You look at the chart and see a recent high at about 27.50 and you place your stop there.
If you look at the chart above you will notice that OII traded below support on the next day but finished the day slightly higher than where you opened your short. The rally took place on light volume so there is no reason to be overly concerned just yet. The next day OII rallied again but on even lighter volume. Right about now you are down by about 1.5%. There is absolutely no way you should be out of this stock. It has hardly moved, and on low volume, no less.
Even so, you begin to tighten your stops to protect yourself in the event of a significant rally. Now look at the third day. Had you placed your stop directly on top of the previous day’s high you would be out – out of a perfectly good trade. Again, volume was light. Let’s say you did place your stops too tight and you were taken out of a good trade. Can you get back in? No question, remember that timing is everything. Move onto the next chart.
Now aren’t you glad you are still in this stock? OII entered a near free fall and stopped promptly on the target of 20.00. Do you take your profit here? The answer is a profound, Yes!! Remember, you give your stock a chance to run past its target on an intra-day basis, only. This stock stopped smack dab on the target of 20.00 – you take profits relentlessly here. Yes, the stock traded lower the very next day, but as I said earlier – no one can trade the exact tops and bottoms of the market. No one!
Look at the volume as the bottom is put in. It’s very high isn’t it? Funny how that happens, there are always plenty of sellers at the bottom but you are no longer going to be one of them – now you are covering your short at the bottom! Not long after you took your profits OII rallied pretty violently and… you are looking really good. Nice trade!
Putting it all Together
When we talked about taking a small loss on AAI and AOL you may have been thinking, “Why take a small loss when it turned out to be a good trade only a few days later? Why not just ride the trade out?” The simple answer is… how do you know where the rally or drop will end? How do you know your stock won’t turn into a BLS or CGNX? How do you know that? You don’t and if you let your stocks move against you without cutting your losses early your small losses will eventually turn into big losses.
You must take your losses fast and keep them small. This is the only way you will be around to place the next trade on the same stock or a different stock. You may get away with this on a few occasions but in the long run this type of trading will get you into trouble. It is not uncommon for me to trade the same stock more than once before I get a successful result.
The way you enter a position will dictate the way you exit a position. Let’s say your entry point is just over resistance, at 20.00. Your ideal buy point is 20.01. Chances are you won’t get that exact price and you will have to buy higher. So, how high it too high? The answer for me is based on where I can comfortably place my stop. Let’s say you buy at 20.10. Your arbitrary stop loss is at 18.09. You then look for a recent low and adjust accordingly. But what if you bought the stock at 20.70?
Your arbitrary 10% stop then becomes 18.63, which means you have to begin with at tighter stop than you would if you bought at 20.10. Or, you can place a stop according to the 10% rule and an entry point just above 20.00, but that exposes you to more and unnecessary risk. It is very important to be very selective about your entry points. The closer to support/resistance you enter your position, the better. Don’t ever feel as though you “missed the boat.” The markets aren’t closing and another boat will be along shortly.
Let’s talk about the 10% arbitrary stop rule. How many of these examples actually turned out to be a 10% loss? Correct, none. Remember, I just use this as a starting point and plan to keep adjusting the stop according to what the stock does. One note however, it is not uncommon for a stock to break support and rally right past your entry point, continue on another 10%, and take you right out.
If you are going to place the 10% stop I suggest you watch your stock very closely on the first day of the trade. I never really anticipate taking a 10% loss; I just find it a good starting point. If you don’t have the time to watch your stock all day, then determine a stop that is more suitable to your tolerance for loss.
Let’s do a quick review. When a stock breaks out you want to buy it just above resistance and look for volume to confirm the move. A stock doesn’t always work out immediately, but you still give it a chance. Volume can show up after the break out. You find yourself in a profitable trade and the stock is approaching your target.
What do you do? You give it every opportunity to run by its target – don’t get in its way. If your stock stops right on the target it is time to take profits. Always use stops and when the stock moves against you, you tighten stops in an effort to keep your losses small. In the early part of a trade don’t place your stop directly on the high/low of the day because in doing so you risk getting stopped out at the open only to find your stock move in the direction you want later in the day.
What I have described today is a very mechanical way of trading. This is just a stepping stone to becoming a successful trader. Market conditions are constantly changing and you, “The Trader,” have to change with them. If you are long at the top of the market you don’t let your profits run; you simply take them when the time is right.
The same goes with going short at or near the bottom. Trading takes experience. You can’t expect to trade successfully from reading articles or books. You actually have to get in the cockpit and start trading. You can’t learn how to fly a plane by flying in a simulator. There are conditions in the real world that just can’t be imitated in a simulator. The same goes for the markets.
Trading is just a business. From a psychological standpoint, profits are revenues and losses are expenses. If you find yourself in a stock that isn’t working for you just fire it – no questions asked… you just fire it. Companies with bad employees go out of business; traders with bad stocks go out of business. Keep the winners, fire the losers.
If you find yourself in a stock that is making you money then you simply let it continue to work for you until its job is completed. Just try to trade in a methodical, mechanical manner. After you become more experienced you will be able to trade automatically. You will know when it is time to take profits, let the profits run, or take extremely small losses. Trading is just like any other business, the more you do it the better you become at it.