This column was originally published on RealMoney on Feb. 6 at 12:00 p.m. EST. It's being republished as a bonus for TheStreet.com readers.
A reader named Art emailed me last week about placing stops. His initial stop, he says, is typically "between 10%-12% below my purchase price. Bill O'Neil of
Investor's Business Daily
advocates 8%. Others use 20- and 50-day simple moving averages, and still others use support and resistance levels. Can you elaborate on your methodology?"
For a new position, all of the stop disciplines above can be correct or incorrect, depending on your position size. Have you bet your entire account on one position? Never a good idea, but if you find yourself in this exciting position, I doubt you'll want to set your stop 12% below your entry price. On the other hand, if you're using a scaled entry -- always a good idea -- you can be a bit more liberal in stop location, because your risk is minimal. You have the leeway to let the setup play out.
Remember that stops are solely for money management. They contain your downside on those inevitable occasions when you are wrong. So your position size relative to your portfolio size is the most important factor in stop placement, and any of the methods listed above can work just fine, so long as you have enough leeway in your portfolio to sustain a triggered stop.
In a mature or profitable position, position size is important once again. A profitable position assumes an ever-increasing percentage of your portfolio. For example, a position that was 10% of your portfolio on initiation might become 15% or 20% as the position matures. The risk to your portfolio increases as the position works in your favor. You've got to start scaling out.
This concept seems to escape most traders. Half of your position size on initiation of a position is significantly less than half of your position size in a mature position. Again, the risk increases in proportion to your profit -- start taking a bit off the table.
The question in any sideways congestion is always the same: "Is this profit-taking or a top?" You should be a participant in that dilemma. If you've got significant paper profits, then be a profit-taker. The extra cash will keep you warm when the market cools off. Once the sideways congestion ends, the direction of resolution dictates your next move. You can either buy or sell more.
Last week we looked at how to choose the right tool for the right job -- weekly charts for trends, and daily charts for entries and exits. Many readers wrote back about this, so let's look at a few stocks in both weekly and daily time frames.
The uptrend in the weekly chart of
( HANS) is intact, but stochastics are overbought and starting to trend lower. Stochastics reflect momentum of the price action within a specific period of time -- usually 14 periods. The current level of momentum is declining relative to prior periods. Hansen is pulling back, but we don't yet know the magnitude. The
price-by-volume bars tell us that significant support lies down at around $50, but that's too far down to trade responsibly. A higher support level can be seen around $75, but we need to zoom in with a daily chart to get a better feel of the action.
Notice how the stochastics are at an extreme high in terms of downside momentum. This downside momentum has been exacerbated by triggered stops, which only result in more selling. At some point, the demand will be sufficient to halt the downtrend. The high level of churning in December makes it likely that many investors who missed the chance to buy in December are waiting for a second chance. Time and price will reveal their aggressiveness relative to the current selling pressure. If the wide support level highlighted in yellow does not hold, then we know that there just weren't that many people waiting for a second chance, right? So further declines down to the next level of congestion (the mid-$40s) are likely.
Let's apply these concepts to another couple of stocks.
There is significant congestion over the last six months on this weekly chart of
( LRW). At the same time, stochastics gradually declined as slightly lower price lows resulted in higher downside momentum (note that downtrending stochastics implicate a downtrend in price, so a low stochastic reading implicates high downside momentum). But the recent upward stochastic reversal is a real change in character for this stock. Could Labor Ready be ready to break out to the upside and begin the next leg up? Let's look at the daily chart.
It ran from $21 to $26 in just six days, so Friday's reversal was overdue. The ideal initial entry on this stock would be around $22 or $23. That way, downside risk is minimal, because a break below $20 would indicate a failed breakout.
The uptrend in
is mature. The stock broke to new highs a couple of weeks ago, but it was weak last week. Does last week's decline signal the beginning of the end of the uptrend? Not likely, but let's check the daily chart.
It has been pretty volatile over the last six months, but the trend is higher. Stochastics have been making higher highs and higher lows, confirming this uptrend. The current pullback could just be setting up a lower-risk entry for this climber. Just remember that a break of support at $40 will put the stock in no man's land, where minimal trading volume exists. As such, the likelihood of latent buying interest is low.
Be careful out there.
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Dan Fitzpatrick is a freelance writer and trading consultant who trades for his own account. His columns focus on quantitative strategies for trading and investing. Fitzpatrick has lectured throughout the U.S. on the proper use of technical analysis and options trading. At time of publication, Fitzpatrick held no position in any stocks mentioned, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Fitzpatrick cannot provide investment advice or recommendations, he appreciates your feedback;
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