Most investors and many more market pundits continually talk about setting stops; they range from physical stops to mental stops to trailing stops to support stops to retracement stops or even moving average stops. It is easy to set a stop before you enter a position based off of your money management rules such as position sizing and expectancy. If you have a $25,000 account and want to risk 2% of the account on a $50 stock with an 8% stop; we know that the trade will allow you to buy 125 shares with a worst case scenario sell stop of $46.00 (assuming a 1-R risk of $4). This is wonderful but what should a trader do once the position gains 20%? Where should the stop be placed at that point to eliminate the chance of losing that quick 20% gain?

Several books attempt to explain how to take profits and many traders of the past have offered advice in books but most of it is fluff and subjective to opinion. I have heard people claim that they take a third of the position down after making a 20% or 30% gain while other traders take down half the position once a gain reaches 50%; but is this the correct way to manage money and positions? I thought so several years ago but have developed a more mechanical system that gives me precise exits at any time during an up-trend. It is a combination of a trailing stop and a retracement stop based upon the actual gain at any point in time. In a bull market, I will allow the system to loosen itself so I can handle a healthy pull-back without selling before a possible large move. For now, let me focus on my method for locking in profits without giving back too much.

For the sake of this article, I will continue to use the trade suggested above as the round numbers should be easy to follow.
Account Size: $25,000
Risk: 2%
Stop Loss: 8%
Share Price: $50

Shares to Purchase: 125 or $6,250
Sell Stop: $46.00
Worst case loss: $500 or 2%

If you are unsure how I came up with the numbers in this example, please go back and read these blog articles first:
Position Sizing – Why Losing Isn’t Everything

Position Sizing Examples (simplified)

We buy the stock and it is up over 20% after the first three weeks of trading. What should I do to protect the profit I have already made?

Scenario #1:
At $60, I will set a stop based on a 30% profit retracement.
To do this, you need to multiply the profit of 20% (or $10) by a 30% stop: $10*30% = $3
At this point in time, I will look to close the position and lock in gains if the stock drops more than $3 from the $20% threshold ($60 in this case). My trailing stop is now $57 which guarantees me a total gain of 14%.

Scenario #2:
At $65, I will set a stop based on a 25% profit retracement.
As my profit grows, my stop tightens so I don’t give back too much. Again, this can loosen in bull markets and is also subject to longer term support and/or resistance lines. For the sake of this article, we will ignore all other variables.

To do this, you need to multiply the profit of 30% (or $15) by a 25% stop: $15*25% = $3.75
At this point in time, I will look to close the position and lock in gains if the stock drops more than $3.75 from the $30% threshold ($65 in this case). My trailing stop is now $61.25 which guarantees me a total gain of 23% if the trailing stop is violated.

Let’s do this one more time with a 40% gain:

Scenario #3:
At $70, I will set a stop based on a 20% profit retracement.
As my profit grows, my stop tightens so I don’t give back too much. As you can see from the three scenarios, my profit retracement has dropped by 5% as my profit has risen by 5%.

To do this, you need to multiply the profit of 40% (or $20) by a 20% stop: $20*20% = $4.00
At this point in time, I will look to close the position and lock in gains if the stock drops more than $4 from the $40% threshold ($70 in this case). My trailing stop is now $66 which guarantees me a total gain of 32% if the trailing stop is violated.

Please understand that I use these numbers since I like the separation of advances to be at least 10% from one retracement stop level to the next. Any investor or trader can substitute the numbers with something that makes more sense based on your own system and money management rules.

Outside of these selling rules, I also employ additional selling rules that use the long term 200-day moving average and long term support levels and trend lines. In a bull market, I will loosen the tight stops and look for longer term sell signals such as the moving average, a channel breakdown or even strong volatility movements that don’t agree with the overall pattern (these may be obvious reversals on the daily and/or weekly charts). Other times, I have a specific price objective when placing the trade and will close the position if the objective is reached (even if the trend is still higher). A great example of this are the options I purchased in Tenaris (TS); I sold at $45 per call contact, yet they are now trading at $80 per contract. I bought above $10 per contract and had an objective to sell when the stock reached $145 which it did, so I sold my calls and moved on. Looking back, I got out much too early but didn’t violate any of my rules which is more important than the additional gains. If I violated them on this trade and it worked out; what would stop me from violating them in the future and getting slammed with a heavy loss. I hope you get the point.

As I said last night, I am going to upload a simple excel spreadsheet that will allow you to play with position sizing setups and the type of stop that is described above. The stops are integrated into the spreadsheet to show you where to take profits and can be tweaked to your own parameters within your own system. Once I decide where to host the spreadsheet, I will post a link that will allow you to download it.

I will follow-up this article with anther in-depth article that uses a real time trade that I currently have in my portfolio to show you where I will close the position if the price drops. I hope to have the spreadsheet uploaded by that time so you can plug in the numbers to understand on a deeper level.

Piranha

…Question from member about placing trailing stops on stocks with a profit:

Chris,
Thank you for your service, I have begun placing a great deal of faith in your analysis. You made the following statement, “It would be wise to start protecting profits in this stock”. That has always been a difficult proposition for me. What is the best methodology for determining where to place this physical stop? I have been whipsawed before on stocks and then I have place much lower stops only to have the stock keep dropping. What is the best way to place a fairly reliable stop without being premature? Thank you for your help.
MSW Member

My Answer:
Placing a physical stop is subjective and can be considered an art form rather than science. There is not a specific answer to the question but I will let you know how I set a stop in different scenarios. I read a book by Martin Zweig many years ago and agreed with the way he set trailing stops versus what other traders were doing at the time. A popular market system has a stop loss sell rule on the breakout but the 7%-10% doesn’t apply when I have a 30%+ profit in the stock. At times, I like to give my stock some breathing room to give a normal correction that may penetrate a tight 10% trailing stop. Stan Weinstein gives a decent description of trailing stops in his book but sometimes these stops will sell your position prematurely if you buy volatile issues (typically hi-tech stocks).

If a stock I own starts to rise by 25% or more, I will look to raise the mental trailing stop slightly below the most recent low or support area (an area I think will receive support). If you cannot locate a support area, using a moving average is the next best thing (set the stop slightly below this moving average only if it has given support in the recent past). If a moving average hasn’t provided recent support then it doesn’t make any sense to use this line as a stop reference. An important factor when setting a stop is looking at the overall “M” in CANSLIM. Investors can give more leeway if the major indices are moving higher and the trend is bullish. In poor markets or volatile sideways markets, it would be wise to set your trailing stop tighter to protect from any bad news that may hurt your profits.

If you cannot locate a support area (point and figure charts will help with this), draw a trend-line that connects several recent lows and think about placing a stop slightly lower than this line. If the trend-line is drawn at an angle greater than 60 degrees, ignore this method as a pullback is probable due to the nature of the sharp up-trend. Over the years, I prefer to use trend-lines that represent support and/or resistance in a horizontal nature. If you look at the MSW chart analysis (through our link – members only), you will see that I have drawn trend-lines for the major market indices (both horizontal and angled). If the NASDAQ was to break one or both of these trend-lines, I would start to become bearish and defensive with my portfolio and many if not all of my mental stops would be transferred into physical stops to protect profits or possible losses in new positions.

I often look at the history of the stock (2-years) to see how it has corrected in the past. Using SIE as an example, I have kept it on the MSW Index while it corrected below the 50-d moving average because it did so in the past and I felt confident that it would continue the trend above the 200-d moving average. My stop in this case was just below the 200-d moving average, a line it respected for years. Any sharp drop below this line would present immediate danger and I would want to be out of the position as soon as possible. This method proved to be correct as the stock eventually ran from the low $60’s into the low $80’s without violating the longer term moving average.

Determine what a reasonable reaction would be in the specific stock that you are trying to set a stop for. Look at the stocks you have placed stops for in the past and determine if they were volatile hi-tech companies or slowing moving larger cap stocks that are more predictable. For a quick example, I would give Whole Foods (WFMI) a much larger trailing stop than I would with OptionsXpress (OXPS) because of their different histories and sectors. Both stocks are on the MSW Index for the same reasons but I must treat them differently because they act differently.
Piranha

…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