Placing Stock Sell Stops

…If you follow my articles or my stock analysis, you already know that I am not a supporter of physical sell stops due to the fact that market makers can manipulate these stops during the day. A market maker can drive the price down artificially during trading hours setting off physical stop after physical stop only to allow the stock to rebound and close for a slight loss or a possible gain. The market makers that drive down the price are the same individuals that grab shares at the new intraday price lows, giving themselves an instant profit at the expense of investors like you and me. I fell victim to this trap several times in 2002 and 2003 and became very angry at my stock system until I understood what was really happening. I had established positions in stocks and set a physical sell stop about 7-10% lower to protect from a larger loss. I would come home or take a break only to see that I was automatically sold out of the stock due to a brief drop that only lasted a few minutes to a few hours. The stock would drop anywhere from 15% to 25% intraday only to rebound for a small 1% or 2% loss. In one case, my stock that had been sold out intraday actually managed to close the day with a slight gain, really making my emotions rage. This same stock went on to double over the next nine months but I never had the courage to get back in. I took this anger and quickly converted it into a research effort that would help me understand what had happened and why it had happened and most importantly: What can I do to prevent it from happening to me again?

I started to study the three instances where this action happened to me and I researched other stocks that I did not own but showed the same type of false intraday movements. After reading about market makers and my individual research, I came up with a solution to the problem. If I narrowed down my portfolio to only high quality stocks, both fundamentally and technically, I knew that my risk was low enough to withstand an intraday movement without placing a physical stop. Barring a catastrophic event, I felt comfortable enough to set a mental stop in my head and write it down on a piece of paper so I could review the stop after the day’s close. If a stock I own drops below my mental stop, I will either sell “at the market” first thing the next morning or I will wait for the first hour of trading to end and then make my decision to sell. If the mental stop has been passed by more than 5%, I sell immediately the next day. If the metal stop is only sliced slightly (less than 2%-3%) I will hold until mid morning or early afternoon to sell my shares. Typically, when a stock violates a mental stop that I set; it will drop even further during the first hour of trading but will then rebound as the day moves on, allowing me to take a lesser loss. This is risky but it has been a plan that I have been following for two years with success.

The other more important advantage that mental stops give over physical stops is the prevention of getting sold out intraday during a false breakdown. Since Tower Group (TWGP) is currently on the MSW weekly screens, I will use it as a perfect real time example. Below are the open, high, low and closing prices for the past two days in Tower (the stock has not reached an intraday low below $16 in the past several weeks).

Monday: 19.64 open, 19.81 high, 18.53 low, 18.87 close
Tuesday: 18.86 open, 19.02 high, 15.37 low, 18.49 close

As you can see, the stock went as low as $15.37 on Tuesday only to close back up at $18.49 (a gain of 20% from the intraday low) but what you cannot see without an intraday chart is the fact that this entire move took only 90 minutes of the trading day. Within minutes of the opening bell, the stock dropped 20% but rebounded with strides over the next 90 minutes bringing the price back to the $19 level. From that point forward, the stock gradually fell and lost about 2% for the day but it wasn’t anywhere near the 20% drop from the first hour of trading. If you had a physical stop near $18, a short term support level, you would have been sold out even lower during the intraday drop and would have a large loss in your portfolio. If you had a mental stop, you would not have been sold out and could have made a rational decision on Tuesday night to see if you would like to sell the next day because your mental stop had been violated. The stock managed to close above $18 per share but a major red flag was issued and in most cases, I would sell the next day to be safe. I would then wait after selling the stock to see what direction it was going to take and if the up-trend would continue. If the up-trend continued, I would jump back in at the first solid opportunity.

Some investors think I am raising my risk without using physical stops but I know I am helping my odds by assessing the situation at the end of the day by placing mental stops. I only place physical stops on a position that is showing at least a 20% gain and I will give it room to breathe. If the stock shows a 50% or 100% gain, I will place a physical trailing stop to protect my gains from melting away but I will not place a physical stop on a stock that I just purchased. Too many times during the initial stages of a breakout, market makers will wipe out all of the physical stops and restart the movement without the heavy domino load below. These market makers know about “popular market trend systems” and they can see where these stops are placed; so they wipe them out, allowing themselves to get in at a lower price and they release the possible sell-off due to hundreds, if not thousands of stops that have been set due to a specific system strategy. Unless you are investing in high quality stocks with strong fundamental and technical ratings, do not employ this strategy or you can lose your entire trading stake. The strategy is a suggestion based on the results it has given me over the past several years after the bad personal experiences that I had with market makers in the past. They may burn other investors, but they no longer burn me – only I can burn me!

Chart Link: TWGP Chart