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Stick to Your Stops Even When the Market Leaves You All Shook Up

During the past two weeks of indecisive market action, I have been concentrating on individual movements of specific stocks rather than on groups of stocks and herd momentum. Unfortunately, the ranges of the intraday swings continue to be narrow, and there's little momentum to follow.

Tops and bottoms tend to be quick, and multiple bottoms are common instead of clear single bottoms. More fake rallies are shaking traders out of trades. As a result, I am getting stopped out of more stocks than I usually do. A stop is a predetermined exit point I establish whenever I enter a trade. For me, it can range from 1/8 point to 1/2 point below my entry point, depending on circumstances.

In an indecisive market like this, I can be stopped out of a stock and then see it rise -- a missed opportunity. But I am never sorry for taking small stops. I play the percentages, and over time the odds are in my favor if I stick to what works and do not allow the hindsight monster to damage my disciplined trading program.

Here is an example of a trade I was shaken out of last week.

I watched Commerce One (CMRC) climb from the open on Friday and then drop. I was looking to go long when it bottomed. I tried to play the first bottom at 10:03 a.m. EDT and went long at 48. The stock rallied 1/4 point then dropped to 47 3/4, and the selling increased again. I exited with a 1/4-point loss, keeping to my regimented stop-loss program. Commerce One then bounced at 47 1/2, and as you can see from the chart below, it climbed all day long to 50 13/16. Could'a, should'a been a profit of almost three points, but you can never go wrong by keeping to a disciplined stop-loss program. The trade could have continued down three points or even entered a death spiral, turning my momentum trade into one of those pesky dogs that you hold onto for years.

This happened to me all week -- shaken out of trades at the tops and bottoms, missing out on some fairly lucrative runs. On Tuesday, I had my eye on Crossroads Systems (CRDS). I watched it dip a bit at the open, then climb to a high of 10 11/16, where it bounced around at the top for almost 20 minutes. At 10:15 a.m., I noticed many of the other stocks I had been watching that day break down and drop. I entered a short on Crossroads at 10:16 a.m., at 10 5/8. (Shorting involves borrowing shares on the expectation the stock's price will fall. If you're right, you pay back the loan with cheaper shares later on and pocket the difference.)

As you can see from the chart above, Crossroads started to drop around 10:21 a.m. and continued down the rest of the day. The market also turned at this point, as shown below.

I continued to ride my Crossroads short all day because the market was not particularly strong. The intraday ranges continued to be narrow, but for the most part the day was weak. In the last hour I was trying to decide whether to hold my short overnight or exit the trade. At 3:10 p.m., the ratio of buys to sells of the stocks on my screen had shifted to the buy side, which indicated that momentum was picking up. That increased the potential that the Nasdaq Composite Index and Crossroads would gap up (open at a higher point than the previous day's close) the next day. At 3:16 p.m., I covered my short at 9 1/8 for a 1 1/2-point profit.

Crossroads actually dropped some more to 8 17/32 before the close, causing me to miss out on another 1/2 point of profit if I had held. However, my logic was sound, and the exit was in line with my methods.

The Nasdaq and Crossroads both gapped up the next day. Had I remained in my short overnight, I would have cut my profits by half because I would have exited my short at the first opportunity after the gap up.

When the market bounces around in such narrow swings and momentum has little carry through, it can be frustrating. Traders are stopped out more often, and the tendency is to change your methods and chase the market. This is normally the first step in ruining a disciplined approach. Even though the percentages of winning trades are decreased and the number of stops taken increased, overall, being consistent with your methods and not chasing the market will pay off over time.

Ken Wolff is founder and chief executive officer of Paradise, Calif.-based MTrader.com, a daytrading and swingtrading educational Web site. This column is intended to provide general information about momentum trading. TheStreet.com has no affiliation with MTrader.com, nor do we necessarily endorse momentum trading. While Wolff cannot provide investment advice or recommendations here, he invites your feedback at ken@mtrader.com.

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