Momentum Trading: Calling a Halt to Missing Stops

When I was young, my mother taught me how to daytrade. OK, not really, but she did teach me how not to lose at daytrading. No, we didn't discuss the intricacies of the market at bedtime. Rather, it was the simple pearls of wisdom she gave me throughout the day that taught me right from wrong (even in the world of daytrading).

Along with "don't talk with your mouth full" and "look both ways before you cross the street," she passed on a bit of advice that would keep me from losing large chunks of my portfolio: "Make a plan and keep to it." How does this translate to not losing at daytrading? Make a plan not to blow your stops. Decide on a stop and keep it.

Keeping a good stop is the No. 1 reason daytraders don't lose. A stop is the predetermined price at which I exit a trade in the event it goes against me. Like all the advice my mother gave, I didn't learn the lesson until I disobeyed it. Here is a common scenario and one that I faced as a beginning daytrader early on in my career. I call it the "death spiral."

It started like this: I entered a trade and the buying continued but the stock did not uptick. Buying dried up, selling increased and the stock teetered. Finally, the stock downticked to my predetermined exit point -- my stop.

Mentally, I noted my stop was hit and I didn't exit the trade. Whatever the reason -- my system went down, my dog sat on my keyboard or I just plain ignored my stop -- I did not stick with my "plan."

At the time, I had been shaken out of several trades by stocks that acted exactly like this, dip 1/4 to 3/8, bounce and then take off for a 1-point gain. I decided that this time, I was going to take part in this profit that everybody else seemed to be making and give the stock a little "breathing room." I was sick and tired of being shaken out of trades, losing a 1/4 point here and a 1/4 point there (plus commissions), then watching as the stock rebounded for what could have been a handsome profit.

The stock continued down past my stop and I waited for the dip and bounce I had seen over and over again. This time it was a bit different. Selling was very heavy and the stock downticked again, then again. I was frozen with indecision, waiting for that one final "sell signal," but the stock downticked again. Panic set in, yet I didn't sell. I kept saying this stock has to bounce here, but it didn't. I saw my portfolio shrink by thousands and thousands of dollars.

The stock continued down. I panicked and said, "If I get out of this trade alive, I swear I will never again fail to keep a stop!"

When panic turned to pain, there were two choices: I could take my medicine and accept the loss (like mamma used to say) or I could hold it and hope (do or die), which is the worst thing I could have done.

Finally, as the stock continued its death spiral and I piled up unimaginable losses, absolute fear set in and I pushed the sell button. To add pain to misery, I ended up selling at the exact bottom as the stock bounced. This scenario didn't take me out of the game, but it took a tremendous loss and a huge part of my portfolio to learn this very valuable lesson. And the whole time I imagined my mother waving her finger at me and saying, "I told you so."

Take a look at the chart for Vicor (VICR Quote), a company that designs, develops, manufactures and markets modular power components and complete power systems. On Feb. 2, the company announced earnings, missing expectations by 5 cents. Investors and traders reacted to this news and the stock gapped down on Feb. 3 and tumbled for the next two days, dropping from 39 to a little over 23 at the close of Feb. 4. If you tried to catch an intraday bounce early on and missed your stop, you would have faced a very serious loss.

Shorting a stock and missing a stop can be even more devastating, especially when the market is strong. Take a look at the chart on Digital Island (ISLD Quote), a leading e-business delivery network, which announced a series of deals that would increase the company's bottom line over the short term. If you misinterpreted the news as not being very strong, tried to short it and missed your stop, you would again be facing a fairly large loss.

It's not just me. It happens to every daytrader at one point or another. When any of my traders blow stops, I suggest they post the event on the wall next to their computers and allow the pain of the event to teach them never to repeat it.

Always know where your exit point is and exit when that point is reached. This seems like a very simple and easy-to-follow rule. So if it's so easy, why is it the most common mistake? Traders who make this mistake are lacking a disciplined approach to trading.

I take great exception when daytraders are characterized by the media as gamblers, get-rich-quick artists or other unsavory things. Except for a few bad apples, nothing could be further from the truth. Daytrading, when done right, is a legitimate business that requires the same tenacity and planning as any other business. The failure rate of new business startups in the U.S. is staggering. Why? Because of a lack of planning, knowledge and a disciplined approach. If you buy a franchise like McDonald's (MCD Quote), your failure rate is almost zero. Why? Because McDonald's teaches you proven methods and techniques and forces you to follow very strict rules and guidelines that have been shown to work. If you do not follow the rules, you will not continue to operate under the franchise name. In short, McDonald's makes you follow a disciplined approach!

The same approach is required for daytrading. Every successful trader has rules to follow without hesitation. Here are a few of my daytrading pearls of wisdom:

• Don't let your emotions enter the trade. Let the action of the stock determine what you do. Fear and greed will always ruin a disciplined daytrading program and ultimately result in catastrophic losses.

• Make your own decisions. If you follow the herd you will end up at the bottom of a very steep cliff. Never enter a trade based on anything but sound fundamentals of good daytrading.

• Don't let hindsight ruin your disciplined approach. It is easy to look back and see what you should have done; it's difficult to stick to the methods that work time and time again.

• Learn the facts. Stay away from crystal balls or people who claim to have them. Wishing or guessing is the worst thing you can do in daytrading.

• Paper trade until you are sure your methods are profitable.

• Don't force trades. Allow stocks to force you into a trade due to their action. Don't drop into the pitfall of "trying to make it back" after a loss. A loss can turn into a positive experience if you gain knowledge.

• Research profitable methods and techniques and develop your own disciplined approach. Many approaches work -- pick one and stick to it.

• Last but not least, keep your stops. Always, without exception. Without a disciplined stop-loss program, you are gambling, and a day job is just waiting to happen.

Thank you for the many emails and kind comments on the column. Many of you have requested that I write about specific daytrading methods and techniques. I plan to do exactly that over the next few months. And I promise not to sound like your mother.