STOP LOSS ORDERS: HOW SHOULD THEY BE SET?

One of the most difficult arts in swing trading is setting the stop loss order. Put the stop loss too close to your entry price and you are liable to exit the trade due to random market fluctuations. Place it too far away, however, and if you are wrong on the trade, then a small loss could turn into a painfully large one.

A stop loss is an order placed with your broker that will automatically close your trade when the stock you are trading reaches a predetermined price. When the stop level is reached, your stop becomes a market order and the shares you hold are liquidated. Most brokers will allow two types of stops – "good until cancelled" (GTC) and "good for the day." (Please note that, in practice, many "good until cancelled" stops will need to be reinstated at the beginning of each new trading month. This of course will depend upon which broker you use.)

Although most traders advocate placing stops, it is worth noting that this practice has its skeptics. Long-term, fundamentally oriented investors will tell you that when a stock goes lower, it doesn't necessarily mean you should sell. In fact, if the fundamental story that motivated the purchase remains intact, it might actually signal a buying opportunity instead. Critics of stops will point out several disadvantages of the stop loss order. By placing the stop you are guaranteeing that, should your trade move in the wrong direction, you will end up selling at lower prices, not higher. If you are unsure about the position, then why not just bite the bullet and sell instead of waiting for a decline to take you out of the trade?

The skeptics will also argue that in setting stops you are vulnerable to their being "run." Most traders have probably had the experience of setting a stop loss, seeing the stock price retreat to that level, or just below, and then go zooming into the stratosphere. What might have been a profitable trade instead turns into a loss. Given that stop loss orders tend to congregate at key points, when one stop is touched, others are set off (like dominos). Because the stop becomes a market order when hit, you also may be forced to exit your trade at a lower price than your stop was set at. That is particularly true with thinly trading stocks.

So, with all of these disadvantages in mind, why would traders ever want to set stops at all? Well, almost all trading experts will tell you that stop losses are an important part of trading discipline, as they can prevent a small loss from becoming a disastrously large one. What's more, by diligently setting stop losses whenever you enter a trade, you end up making this important decision at the point in time when you are most objective about what is really happening with the stock.

During instances when I cannot monitor an open trading position, I will also always make sure to set a stop. That is certainly true if I travel and am away from the market for more than a day. But it is also the case intra-day when I can't watch an open position even for a few hours in real time. Unexpected news can come out of the blue and dramatically affect a stock's price. There is also an important saying I try to practice -- "The first loss is the best loss." In other words, when a position is going against you, it is best to cut your losses immediately. Again, if you set your stop loss when you enter a position, then that is when you are most objective. By doing so, you save yourself the emotional difficulty of deciding when to "cry uncle" if the stock is going against you.

A key question for swing traders is exactly where to place a stop loss. In other words, how far should you place the stop below your purchase price? Many traders will tell you to set a predetermined "maximum acceptable loss" amount based on your personal account rather than technical analysis of the stock in question. One line of thinking says that you should not lose more than -2% of your equity on any one trade. If you have $60,000 in stock market capital, then that would mean the maximum loss you would accept on any one trade is $1,200. If you risked $6,000 by buying 600 shares of a $10 stock, then you would limit your risk to no more than $1,200. In that case you would set your stop loss at $8 and would have $4,800 left if you exited the position at the maximum loss allowed.

Another method of setting stop losses is to predetermine an arbitrary percentage of your purchase price you are willing to lose. One well-known figure -- suggested by William O'Neil, publisher of Investor's Business Daily -- states that you should never lose more than -8% of your position on any given trade. In the case of the above example, you would set your stop loss at $9.20, or 8% below $10. For swing trading, I have found that -8% losses are unacceptably high. As such, almost all recent trades I've suggested in my Swing Trader newsletter have stop losses between approximately 4 and 6%.

Although predetermined amounts are useful for preventing unacceptably large drawdowns in your account balance, they unfortunately have nothing to do with the stock's behavior itself. The market doesn't know at what price you bought the stock or what your overall account balance is, nor does it care. As such, stop losses that are set as arbitrary amounts leave traders vulnerable to being kicked out of a position for no reason other than normal market volatility.

Let us take the example of Cognizant (CTSH) -- a stock currently on our watch list and one that I analyzed in detail in our October 4th Swing Trader issue. CTSH remains in a strong uptrend, trading above rising 30-, 50-, and 150-day moving averages and continues to demonstrate excellent relative strength versus the broader market. For the sake of example, let's imagine you bought 300 shares at Thursday's close of $31.12 for a total investment of $9,336. Let's also assume that your total account size is $60,000.

Limiting your loss to 2% of your account size, or $1,200, would mean setting your stop at $27.12. Meanwhile, limiting your loss to 8% of the stock's price would see the stop set at $28.63. Although these two methods may suggest absolute amounts that are not that far apart, they ignore key technical levels shown by the stock itself. Neither of these stop losses has anything to do with the important technical support or resistance levels seen in the chart. As this example shows, setting stops based only on personal information is apt to lead to poor swing trades.

What then is the answer to how to set stop losses? My answer is that very careful technical analysis of both the hourly and daily charts are needed to determine the level at which a trade is not acting "as it should" if it is going to be profitable. I will develop this thought in detail next week. 

COMBINING THE DAILY AND HOURLY CHARTS IN SETTING THE STOP LOSS

One of the most difficult arts in swing trading is setting the stop loss order. Put the stop loss too close to your entry point and you are liable to exit the trade because of random fluctuations. Place it too far away, however, and if you are wrong on the trade, then a small loss could turn into a painfully large one.

Last week I discussed the practice of setting stop loss levels only in reference to one's personal account. One trading methodology says lose no more than 2% of your capital on a trade. Another says you should set your stop loss at a maximum of 8% on any trade. I expressed skepticism about these methods because they were based on personal information, not market information. They had nothing to do with the underlying stock's technical behavior. I used the example of Cognizant to show that using personal information only, stops would vary between $27.12 and $28.63 -- neither of which represented the true technical level at which the trade should be exited.

What then is an appropriate method? I believe stop losses should be set by combining analysis of both the daily and the hourly chart. The daily chart will typically reveal the stock's Intermediate trend -- the trend lasting one month or more. The hourly chart, on the other hand, will show the Minor trend -- the trend lasting five to fifteen days and sometimes longer. While it can be tempting to use only the daily chart when setting the stop loss, the swing trader should carefully look at the hourly chart for short-term trendlines, support, resistance and indicator information. A final decision should be made by integrating information from both timeframes.

Let's return to Cognizant -- the stock used in last week's analysis. I first placed CTSH on my "Stocks to Watch" list at $29.49 and predicted it would hit a high between $32 and $33 (it reached $33.05 on Wednesday, October 13th). For this example, I'm going to assume the trade was in fact entered at $29.49 and as of Thursday's close of $32.16 there was a profit of +9% to protect. The question becomes, where should the stop loss now be set? (This type of stop loss is called a trailing stop.)

Analysis of the daily chart provides important information. It shows that CTSH has excellent relative strength and that the trendline describing its outperformance of the S&P 500 is intact. On any market strength, CTSH should be a leader and the shares should march higher. MACD is on a buy signal and continues to make new highs. CCI, however, is showing bearish momentum divergence (as price has risen, this indicator has headed lower). That is an early warning flag.

CTSH began the current leg of its uptrend at $19.60 in mid-May. A trendline connecting this low with the late-July and early-August bottoms now intersects the chart near $28. Interestingly, Cognizant peaked at $27.93 in late July and on the pullback in late September hit a low of $27.94. If CTSG were to break this support level and break the trendline, then the reason for being in the trade would be invalidated. The stop can be set at $27.79, a few cents below important support. Right?

If I set the stop loss there, then I would allow a +9% gain to turn into a -5.8% decline. That would violate one of the cardinal rules of swing trading: If at all possible, do not let a profit turn into a loss. The daily chart, at least in this case, does not provide sufficient information for me to appropriately set the stop loss.

An examination of the hourly chart gives me information not clearly available on the daily. For starters, I can now observe that both hourly MACD and CCI are demonstrating bearish divergence -- a clear warning that the stock is losing steam. Further, since September 27th the stock has been rallying, but volume has been declining. That represents bearish volume divergence and is yet another signal that buyers are not eager to pay higher prices as the stock rallies. 

A trendline drawn off the September 27th low now intersects the chart at about $31.05. There is also a small ledge of hourly support and resistance near $31.20. If both of those levels are broken, then CTSH will likely retreat to round-number support at $30 and could pull back even further if the market was very weak. At $30, virtually the entire profit from the entry point of $29.49 will be eroded. In this case, I would therefore set the stop at $30.89 -- far enough below the rising trendline that it should not be hit if the trendline is tested (but not broken). A stop at that level would preserve a portion of the gain while also giving the opportunity to participate in a further advance if CTSH holds support at $31.80 and then moves higher.

In setting stop losses, it's essential to combining the daily and hourly chart messages. If you have not been following this practice in your swing trading, then now may be the time to start.

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