Have you ever sold a stock as it was nearing your protective stop loss price, thinking you would save a bit of money by getting out early, only to painfully watch the stock reverse in the right direction shortly thereafter?
I was guilty of that all the time when I was a new trader back in the ’90s, but I eventually adopted a new trading rule that solved the problem.
Rather than mentally struggling with whether or not to exit a stock ahead of its predetermined stop price, I put into place a clear and objective “set it and forget it” rule that was designed to:
- Eliminate guesswork and mental stress by following a rule-based methodology for exiting trades
- Increase long-term profitability by simply planning the trade, and trading the plan
Obviously, merely setting protective stops every time you enter a new trade is mandatory to one’s long-term success as a stock trader.
However, if one fails to actually follow those exact stop prices, what’s the point of having them in the first place?
Sticking With The Stop In Soufun
In our nightly swing trading newsletter, we are currently holding a position in Soufun ($SFUN) that exemplifies the importance of not exiting a trade ahead of the original stop price.
The annotations on the daily chart below say it all:
On October 17, we bought $SFUN as a momentum swing trade (as labeled on the chart).
At the time of entry, we set an initial stop price of $50.36 ( just below support of the 4-day consolidation period that preceded the breakout).
A few days after buying $SFUN, the price headed south and fell below our original entry price and nearly triggered our stop loss order to sell.
Specifically, the intraday low of October 23 was just 0.4% above our firm stop price of $50.36.
But notice that the price formed a bullish hammer reversal pattern that same day.
In the following session, the price action was extremely volatile, but still held well above both the previous day’s low and 20-day exponential moving average (beige line).
Mind Like Water In A Glass
Obviously, it’s too early to know whether or not the $SFUN trade will eventually work out and lead to a profitable momentum trade.
Since “undercuts” of obvious support levels are common with breakout plays, the trade could indeed easily go on to be a decent winner.
But regardless of the final outcome of this trade, simply utilizing a firm stop price that was determined at the time of entry enabled us to be calm and zen-like, despite whippy intraday price action over the past three days.
Why? Because we planned the trade before buying it, and now we are merely following the plan without the dangerous and stressful human emotions that can easily ruin a winning trade setup.
Proactive Vs. Reactive Trading
Many traders tend to sell a stock just before it hits the stop because they figure that the stop will get hit anyway, so it’s better to save a bit of money by getting out early.
Selling a position when the price is around 0.5% to 1.0% above the stop price is being reactive…and that’s NOT how successful traders make money.
On the other hand, it’s completely fine (and recommended) to adjust your stop price from the original plan if you’re being proactive instead.
To explain the difference, there are two main situations in which a trader is being proactive with regard to adjusting a stop price:
- The stop price is well below the current price, and a sudden change in the price action of the stock has warranted the stop price being tightened. An example of this would be a stock that is acting fine, but suddenly gaps sharply lower due to an unexpected news event. If the stop price is still substantially below the current price of the stock, it often makes sense to raise it because the odds of the trade working out have now been greatly diminished.
- A winning trade has racked up a large unrealized gain from the entry price, but is nearing a major level of price resistance. In this case, raising a stop higher (such as just below the most recent “swing low”) makes sense because it is being done in an attempt to protect profits, but without necessarily choking off further potential gains. For us, an actual recent example of this can be found with U.S. Silica ($SLCA). Going into October 24, our initial position of $SLCA was showing an unrealized gain of 50.3% since our July 8 buy entry, while the shares we added on August 14 were up 37.3% from our buy entry of $23.64. In order to protect profits, we alerted Wagner Daily subscribers that we were raising the stop to $31.60 on the most recently added shares. That tightened stop got hit the same day, enabling us to lock in a gain of 33.7% on partial position size (our original position is still open because we intend to hold through the current pullback).
By engaging in either scenario above, a trader is being proactive.
But in most other situations, exiting a trade before it hits the exact, predetermined stop price is being reactive.
Proactive traders are not only more profitable than reactive traders, but they also possess calmer minds because they remove the stressful decision making that reactive traders constantly torture themselves with.
The only way to know if you personally are being proactive or reactive with regard to stop placement is to do an honest assessment of how you have been managing recently closed trades.
Then, ask yourself if you have been planning the trades (accepting risk), and then trading the plans (executing)…or have you frequently been failing to just let the original trade setups play out?
If you answer the latter, make the decision right now to begin sticking to your plan by using a “set it and forget it” approach to setting stops.
When you do, you’ll be amazed at the mental freedom and additional profits you will gain.
What are other things you do that help you to have a “mind like water,” while increasing your profitability? Share your thoughts below.