Surfboards don't have brakes and neither do markets. But Surfboards do have safety lines that surfers strap to their ankles called leashes to prevent them from losing their surfboard on a wipeout. We can't put the brakes on the market anymore than we can put the brakes on a wave, but we can use a safety line to keep us from losing everything in the event of a wipeout as well. In trading, these safety lines are called stops. Basically, a trader places an order to exit at a specific price limit that he is willing to risk so that if the market goes against him he is automatically out, so the theory goes.
Stops are a necessary evil. I say evil because as every trader knows stops have a habit of getting hit just before the market goes your way. The result is that despite being right about the market you are knocked out of it tor a loss and miss the move that would have been so profitable for you. No one likes to use stops to begin with and they tend to bite the hand that sets them. Stops are mean, spiteful and downright ugly animals. Unfortunately, there is one thing even uglier than stops and that is the animal that shows up when you fail to use them. Have the market go against you just one time without a stop and you will agree that this animal is not only ugly, but it makes Jurassic Park look like a petting zoo. This monster will have you shaking all night long like a child with a monster hiding under his bed. So stops are literally the lesser of two evils, or should I say, the least ugly of two monsters.
What makes stops so ugly is the challenge in setting them. You don't want to give away the store so you have to set your stops reasonably close. But if you
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don't allow enough room for your stops then they will get hit every single time and it will nickel and dime you to death. To top it all off, once you start using stops you will swear that someone is broadcasting them to the world because the market always seems to reach just far enough to gobble them up.
Although no one is really looking over your shoulder or setting up a news wire to broadcast your stops, there is some truth that the market knows where they are at and is deliberately reaching for them. There may be no X-Files here, but there is a psychology at work. The problem is that people are so predictable with their stops that the odds are that you are just as predictable right along with them.
Mr. Floor Trader and your stops
I magine for a moment M r. Floor Trader who works on the floor of an exchange. He routinely buys thousands of stock shares trying to extract a quarter of a point from the lot of them. He is not looking for a big move, just any move his way. This type of trading is known as scalping and it is basically reserved for floor traders. So today M r. Floor Trader decides to buy a thousand shares of X YZ Company at 99.75. To make a profit he needs to sell them at a higher price than what he originally paid for them.
Only problem is that he can't dump the entire 1 000 XYZ shares at once or the price will drop with such a large sale and in turn he will lose money.
On top of that, XYZ hasn't traded above 100 all day, so it will be tough to extract a profit. It just doesn't look like it will go much higher, let alone stay there long enough to unload a thousand shares.
So what does Mr. F loor Trader do? Rather than sell his shares at a loss he buys one at 1 00.25. Buy, you ask? Yes, buy at an even higher price than it is currently selling for. He hasn't lost his mind, he is just betting on the psychology of the crowd.
When he buys at this price all of a sudden everyone that is short or had sold X YZ now panics because they were only anticipating at worse a high of 1 00. So stops are then activated and in come a rush of buy orders. At the same time X YZ suddenly catches the interest of traders who hadn't given it the time of day before. "There must be something happening with X YZ". So this brings in even more orders. Our floor trader leisurely sells his thousand shares of X YZ at an average of 1 00.50 and makes a very nice profit. But he hasn't finished with his little ploy yet because he also sells another thousand X YZ stocks knowing that as soon as everybody figures
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out that there was really nothing to move price in the first place it will then just fall right back down to where it was before. So he profits both ways and this happens all too often.
But how did he know that all those stops were there? Elementary, my dear Watson! He knew that the high of XYZ was at 1 00. The stops would be just above this number at 100.25, which is why he bought one share at this price. Actually, most of the stops were probably at 100 because people love to use round numbers, but he wasn't taking any chances. By taking a loss on one share, he makes a killing on a thousand.
In order for Mr. Floor Trader to be successful in creating a momentary panic a number of factors have to l ine up. There are limitations on any manipulation that one person can do, so don't think that there is a huge conspiracy here. Traders who take advantage of these tricks are just opportunists, but the tricks are many and the opportunities present themselves far more often than anyone would care to admit. Most of these tricks are simply based on the psychology of the crowd, which is why it is important to understand that when it comes to trading you simply cannot fit in. The lesson here is that if you don't want to have your stop hit, know where everyone else is setting theirs and avoid those prices like the plague. Otherwise Mr. Floor Trader will come looking for it every time he needs to. Either understand how to set your stops or you will be eaten up alive, one stop at a time.
Setting and forgetting stops
Another psychological minefield that traders walk into is the bad habit of
"setting" a stop and then "forgetting it" only later to be burnt. There is no such thing as "set it and forget it" in trading. But people seem to envision their stop as a sign planted in a concrete roadway and think that moving it would be breaking the law.
When asked about a specific market I am quite often asked, "Where would you set your stop?" Personally, I cringe when I am asked this question. Of course, I have a specific stop in mind and rules for determining where I will set them, but people tend to get hung up on numbers that are quoted while the market itself is in constant change. How do you explain to the average trader that a stop set today will not be the same tomorrow? The concept of a variable stop seems to go against the grain of what most are taught in this business. The rule is to set a stop, lock it up and throw away
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the key. Maybe later when the market establishes a new prominent high or low you can then consider a change, but otherwise it is off-limits. The reality is that setting stops this way is just asking for trouble.
Sometime ago I bought a rotisserie (a rotating cooking appliance) that was heavily advertised on television. The catch phrase that was used over and over was to, "Set it and forget it". People must love this type of convenience because it had some incredible sales figures and continued to be sold for a number of years. Even I fel l victim to this advertising campaign and bought one.
To be honest, the only person for whom this was truly a "Set it and forget it" appliance was my wife who refused to learn how to use it and so all she had to do was to "set me up" to using it and then she could "forget it".
I think the catch phrase should have been "Set up your husband to cook the meals and you can forget about dinner and relax". That would have been a more honest advertising campaign and probably would have had all the wives in every major country buying one for their husbands to use as well. The truth is that if you did "set it and forget it" then your food had a tendency to do some wild and crazy things. For example, a roaster chicken might have a wing pop loose as it continually rotated within the appliance creating havoc with the burner and singeing it.
Similarly, traders have the tendency to do the same thing by placing stops at obvious locations and then leaving them there. Floor traders know where these obvious places are because people are so predictable, so setting and forgetting your stops is often a huge mistake. You can't prevent the market from popping out somewhere you didn't expect and playing havoc on your account. You are sure to end up getting burnt from time and time, or at least singed pretty badly. But even if you never have to worry about Mr.
Floor Trader there is still another reason for never setting and forgetting your stops. A market is in constant change and fai lure to adjust to market conditions leaves you vulnerable to those changes.
For example, what happens when volatility increases? Any stop that you may have set is no longer able to accommodate the wider swings and you will end up taking a loss when your stop is hit. Even if a trend does go your way you are stil l guaranteed a loss if for any reason a stop is reached.
Stops are initially set at a loss and if out of habit you never change it then your set it and forget it will mean a loss every time a market retreats back to the stop's price level. The only time you would actually make a profit is when you manually exit from the market. Think about this for a minute,
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what happens when something just l ies around too long as ifit were dead?
The vultures come along and chew it up. What makes you think it will be any different for your stop if you set it and forget it?
So just setting your stops based on prominent highs and lows and then ignoring them is just asking for trouble, which is exactly what it will bring.
But how else can you approach the placement and movement of stops?
Here again, Channel Surfing comes to the rescue because it automatically sets and adjusts them for you.
As you will recall, whenever your channel l ines are broken you exit, so in essence you are setting a variable stop that fol lows the market. Using channel lines in this way forces you to change your stops regularly with every new data bar. So when trading daily charts your stop is automatically adjusted each day as long as the market continues to move in a trend. Of course, you are actually using two channel l ines and therefore setting two stops, not just one. But even with both sides considered the process is extremely easy to apply because it is done graphically. You simply set your stops just outside of your channel lines and when it crosses either of them you exit. But what is done graphically can also be done mathematically and there are reasons why you may need or want to do it this way.
Calculating stops mathematically
I f you were day trading and using a five minute chart t track your trades then it would be redundant to send your broker a stop every five minutes. It would become obsolete within minutes of submitting your order. So a day trader is better off just watching the channel lines and using them as "stop lines", exiting whenever the market exceeds them. However, if your trading style requires that you submit a stop order then you will need to calculate your stops mathematically. I magine calling your broker and tel ling h im to get you out of the market when it exceeds a channel l ine. You would be the joke of the day in his office. If you want to submit a stop order you have to provide it in the form of a specific price. Position or short-term traders usually have to submit their stop orders in this way. Fortunately, figuring out a specific price is a simple mathematical calculation that can be done either by hand or more conveniently, by using a spreadsheet.
Throughout this chapter there will be examples where daily charts are used to determine the placement of a stop, but the principles are the same for any time frame that you may be considering.
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The first task is to draw channel l ines and determine the date (or time) of the highs and lows that generate those lines and their prices. Figure 6-1 provides our first example chart and shows a trend where the Channel lines are already drawn. I have taken the liberty of writing the highs and lows ( H=high & L=low), as well as the dates (month & day), of the bars that are touching either channel line. For our purposes there is no need to worry about any highs or lows that are not actual ly touching a channel line.
To determine trading days. Include both bars that establish your highs or lows in your count.
Once we have the prices and dates (or times) of our highs and lows, our next step is to determine the average price change of the channel line each day (or data bar). This figure is then added (or subtracted) against the current value of the channel line to give us the channel's limit for each succeeding day.
For example, in the case of a supporting channel l ine in an up trend we would take the lows that have touched the line and calculate the difference between the low and the date. The elements of the calculation are:
A = 1 st low price B = 2nd low price X = 1 st low date Y = 2nd low date
Z = Average price move per data bar for the channel
Based on these elements, the calculation is: Z = (B-A) / (Y-X)
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In other words, the 1 st low price would be subtracted from the second low price, giving the total price difference between the two. Subtracting the 1 st low date from the second low date would provide the total difference in days between the two lows. Remember to subtract any non-trading days from this calculation since you are only interested i n the actual trading day difference. Then divide the price difference by the number of days and you come up with the average daily price move that needs to be added or subtracted from each day to continue the channel 1ine.
The upper channel line would be calculated in similar fashion, only the highs that touched the upper channel would be used. Of course, if you were dealing with a channel that was bearish then the calculation would be in reverse order.
The calculation would look l ike this: Z = (A-B) / (X-Y).
So the only difference would be that the order of A and B which would be switched, as well as the order of X and Y. Or so it is easily remembered, you always subtract the lower number from the higher number to get the difference.
Having established the calculation of the channel lines and using the highs, the lows and the dates from our previous chart (Figure 6-1), let us determine what the stops will be for the next several days.
Starting with our inside channel l ine (Supporting trend line), we have the following:
33.39 - 3 l .00 = 2.39
(2nd L) - ( l st L) = Price Difference
December 3 1 't - November l JIh = 33 trading days
Take out any non-traded days such as weekends and holidays. Here, Christmas and Thanksgiving [USA holidays] and several weekend days require 1 6 days to be subtracted from the actual total of 49 calendar days.
The easiest method for determining trading days is to simply count the actual bars, starting with and including the first low/high and each bar up to and including your last low/high bar.
2.39 / 33 = .0724 (Average Price Difference)
Based on these calculations, you would add .0724 to each succeeding day to determine where the price level of the Channel l ine would be for that day.
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So the next trading day fol lowing your last date of December 3 1 '1 should have no lower low than 33.4646
33.39 + .0724 = 33.4624.
You can then add .0724 to any calculated day to find the next day's low.
For example, the next few days will follow a sequence of33.5348, 33.6072, 33.6796 and 33.7520.
Simply set a stop just below the expected low (never place a stop at the actual calculated number since this is what price is allowed to reach) and fol low it with a new calculated stop for each succeeding day.
Calculating the upper channel line is just as easy.
38.2 1 5 - 35.25 = 2.965 (Price Difference)
January 2 1SI - November 22nd = 39 (Trading Day Difference) 2.965 / 39 = .076 (Average Price Difference)
Based on these calculations, add .076 to each day to calculate this channel l ine. The day fol lowing your last date (January 2 1 SI) should have no higher high than 38.29 1 .
38.21 5 + .076 = 38.291
Simply add .076 for each succeeding trading day that fol lows to calculate the maximum high for each day.
The next few days to follow will calculate as: 38.367, 38.443, 38. 5 1 9 and 38.595.
In this particular case, you will notice that the average price difference is slightly different between the two channel lines. This is not unusual.
Although channel l ines are parallel, they are often not perfectly aligned.
You will need to recalculate from time to time because the market has a way of compensating for these differences and does so quite often.
Now that we know how to calculate the numbers for our channel, we need to determine our stops. Why couldn't we simply use the numbers we have already calculated? Because these numbers are the limits of the channel lines and so price is expected to actually reach them. Therefore, it will naturally hit these numbers regularly. Price has to actually break a channel line (or exceed our numbers) to signal a change in trend. So how much breathing room do we allow?
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This depends on how aggressive you want to trade. You can set your numbers at the very minimum price movement above or below your channel lines. In the T-Bond for example, the minimum price movement
This depends on how aggressive you want to trade. You can set your numbers at the very minimum price movement above or below your channel lines. In the T-Bond for example, the minimum price movement