Stop loss orders

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It was the same with all. They would not take a small loss at first but had held on, in the hope of a recovery that would “let them out even.” And prices had sunk and sunk until the loss was so great that it seemed only proper to hold on, if need be a year, for sooner or later prices must come back. But the break “shook them out,” and prices just went so much lower because so many people had to sell, whether they would or not.

—Edwin Lefèvre

The success of chart-oriented trading is critically dependent on the effective control of losses. As mentioned in Chapter 7, it is not necessary to be right half the time; what is necessary is limiting losses on bad trades sufficiently so that winning trades are substantial enough to return a profit. Accordingly, a precise stop-loss liquidation point should be determined before initiating a trade. The most disciplined approach would be to enter a good-till-canceled (GTC) stop order at the same time the trade is implemented. However, if the trader knows he can trust himself, he could predetermine the stop point and then enter a day order at any time this price is within the permissible daily limit.


How should stop points be determined? A basic principle is that the position should be liquidated at or before the point at which price movement causes a transition in the technical picture. For example, assume a trader decides to buy the stock in Figure 9.1 after the April 1995 upside breakout has remained intact for five bars (weeks). In this case, the protective sell stop should be placed no lower than the lower boundary of the April 1994–April 1995 trading range, since the realization of such a price would totally transform the chart picture. Some of the technical reference points commonly used for placing protective stops include:

1. Trend Lines. A sell stop can be placed below an uptrend line; a buy stop can be placed above a downtrend line. One advantage of this approach is that the penetration of a trend line will usually be one of the first technical signals in a trend reversal. Thus, this type of stop point will strongly limit the magnitude of the loss or surrendered open profits. However, this attribute comes at a steep price: Trend line penetrations are prone to false signals. As discussed in Chapter 3, it is common for trend lines to be redefined in the course of a bull or bear market.

2. Trading Range. As illustrated in the preceding stock example, the opposite side of a trading range can be used as a stop point. Frequently, the stop can be placed closer (particularly in the case of broader trading ranges) because if the breakout is a valid signal, prices should not retreat too deeply into the range. Thus, the stop might be placed somewhere in the zone between the midpoint and the more distant boundary of the range (see the dashed line representing the midpoint of the trading range in Figure 9.1). The near end of the trading range, however, would not be a meaningful stop point. In fact, retracements to this area are so common that many traders prefer to wait for such a reaction before initiating a position. (The advisability of this delayed entry strategy following breakouts is a matter of personal choice: In many instances it will provide better fills, but it will also cause the trader to miss some major moves.)

3. Flags and Pennants. After a breakout in one direction of a flag or pennant formation, the return to the opposite end (or some point beyond) can be used as a signal of a price reversal, and by implication a point for placing stops. For example, in Figure 9.2 the dashed line marks the stop level indicated by the lower boundary of a flag. After the upside breakout of the flag, a penetration of this level would imply a reversal of the current uptrend and require liquidation of the long position.

Figure 9.2: Stop placement following flag pattern breakout—DuPont.
Chart created with TradeStation^® by Omega Research, Inc.

4. Wide-Ranging Days. Similar to flags and pennants, after a breakout in one direction, the return to the opposite end can be used as a signal of a price reversal, and hence a point for placing stops. For example, in Figure 9.3 note how the return of prices back to below the true low (see Appendix) of the wide-ranging up day formed in mid-September (after initially trading above this pattern) led to a major price collapse. 
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Stop loss orders