Catastrophic Stops: A Professional’s Life Jacket

Soon after moving to a house near a lake I bought a kayak, and immediately went shopping for a life jacket. All I had to do to be legal was to have a jacket in the kayak—any cheap piece of junk would suffice. Still, I spent good money on a quality jacket that felt snug and didn’t interfere with rowing when I wore it.

All I planned to do with that kayak was to paddle peacefully on a lake, not anywhere near white water or currents. I never expected to actually need that jacket. Did I waste my money buying it? Well, if ever some motor boat clips me, then wearing a high-quality jacket can make the difference between life and death.

It’s the same with stops. They’re a nuisance and often cost you money. Still, there will be a day when a stop will save your account from a life-threatening collision. Keep in mind that a bad accident is much more likely in the market than on a lake. That’s why it’s essential to use stops.

A “hard stop” is an order you give to your broker. A “soft stop” is an order you keep in your head, ready to place it when needed. Beginners and intermediate traders must use hard stops. A professional trader, sitting in front of a live screen all day, may use a soft stop if he has the discipline to exit when his system tells him to do it.

Still, accidents happen. A professional trader friend described how he fought against a market reversal. His soft stop was set at a $2,000 loss level, but by the time he threw in the towel and got out, his loss grew to $40,000—the worst of his trading career. This is why, even if you don’t use hard stops on a regular basis, you should at the very least use a “catastrophic stop” for every trade.

For any A-trade, whether long or short, draw a line on your chart where you absolutely do not expect that stock to go. Place your hard stop at that level and make it GTC: “good ’til cancelled.” That will be your catastrophic stop. Now you can play with the luxury of soft stops. Paddle your kayak hard, knowing that you’re wearing a reliable life jacket.

Had my friend whose $2,000 drawdown metastasized into a $40,000 loss used a hard “catastrophic” stop, he would have taken only a relatively small loss, sidestepped a disaster, and avoided the financial and psychological hurt of a shark bite.

Stops and Overnight Gaps: Only for the Pros

What will you do if your stock gets hit by a major piece of bad news after the market closes for the day? Looking at pre-opening quotes the next morning, you realize that it’ll open sharply lower, deep below your stop, promising massive slippage. This is a rare occurrence, but it does happen. If you’re a new or intermediate trader, there isn’t much you can do—just grit your teeth and take your loss.

Only coldly disciplined pros have an additional option: day-trade your way out of that stock. Pull your stop, and after the stock begins trading, handle it as if it was a day-trade you bought at the first tick of that morning. Opening gaps are often followed by bounces, giving nimble traders an opportunity to get out at a smaller loss.

This doesn’t always happen—which is why most traders should never use this technique. You may actually deepen your loss instead of reducing it. Be sure to get out before the close. Your damaged stock may bounce today, but tomorrow more sellers are likely to come in and drive it lower. Don’t let a bounce lull you into a false hope of a reversal.

Is This an A-Trade?

Your performance in any field will improve if you take tests. Getting graded on them will help you recognize your strengths and weaknesses. Now you can work on reinforcing what’s good and correcting what’s not. Whenever you complete a trade, the market gives you three grades.

It grades the quality of your entry and exit, and most importantly, it delivers your overall trade grade. If you’re a swing trader and use a combination of weekly and daily charts, look for your grades on the dailies. Your buy grade is based on the location of your entry, relative to the high and low of the daily bar during which you bought.

                                        Buy grade = (high–buy point)/(high–low)

The closer to the bar’s low and the farther away from the bar’s high you buy, the better your buy grade. Suppose the high of the day was $20, the low $19, and you managed to buy at $19.25. Entering those numbers into the formula gives you a buy grade of 75%. If your buy grade is 100%, it means you bought at the bottom tick of the day.

That’s brilliant, but don’t count on it happening. If your buy grade is 0%, it means you bought the top tick of the day. This is terrible and should serve as a reminder not to chase runaway prices. I calculate my buy grade for every trade and consider anything above 50% a very good result, meaning I bought in the lower half of the daily bar. The following is the formula for your sell grade
                                           Sell grade = (sell point–low)/(high–low)

The closer to the bar’s high and the farther away from the low of the bar you sell, the better your sell grade. Suppose the high of the day was $20, the low $19, and you managed to sell at $19.70. Entering those numbers into the formula gives you a sell grade of 70%. If your sell grade is 100%, it means you sold at the top tick of the day. If your sell grade is 0%, it means you sold at the bottom tick of the day. This terrible grade should serve as a reminder to sell earlier instead of panicking. I calculate my sell grade for every trade and consider anything above 50% a very good result, meaning I sold in the upper half of the daily bar.

When evaluating any trade, most people assume that the amount of money they make or lose in that trade reflects its quality. Money is important for plotting the equity curve, but it’s a poor measure of a single trade. It makes more sense to rate the quality of every trade by comparing what you’ve got to what was realistically available. I find my trade grade by comparing points gained or lost in a trade to the height of the daily chart’s channel measured on the day of the entry.

                                   Trade grade = (sell–buy)/(channel high–channel low)

A well-drawn channel contains between 90% and 95% of prices for the past 100 bars. You may use any number of channels—parallel to the EMA, Autoenvelope, Keltner, or ATR channels—as long as you’re being consistent. A channel contains normal price moves, with only the extreme highs and lows protruding outside it. The distance between the upper and the lower channel lines on the day you enter a trade represents a realistic maximum of what’s available to a swing trader in that market. Shooting for a maximum, though, is a very dangerous game. I consider any trade that gains 30% or more of its channel height an A-trade.

FIGURE  ADSK daily with 13- and 26-day EMAs and a 7% envelope. Impulse system with MACD-Histogram 12-26-9. 

A comment by Kerry Lovvorn at the 2012 annual reunion of SpikeTrade grabbed my attention: he challenged all participants to define what he called ‘an A-trade’—a setup that signals the likelihood of an excellent trade. “You have to define this pattern for yourself,” he said. “If you don’t know what’s your ‘A-trade,’ you have no business being in the market.” I knew full well what my A-trades were—a divergence coupled with a false break-out or a pullback to value. Still, if I saw no A-trades on my screen, I’d go for B-trades, and on a really slow day, reach for a C-trade.

FIGURE  The Strategy box in the Trade Journal. 

Returning home from that reunion, I attached a plastic strip to one of my trading screens with the question: “Is this an A-trade?” Ever since then, I have it in front of me whenever I place an order. The results came quickly: as the number of non-A-trades sharply declined, my equity curve began to rise at a steeper angle. You need to have a clear idea of what would be a perfect setup for you, “an A-trade.” Perfect doesn’t guarantee profits—there are no guarantees in the market—but it means a setup with a strong positive expectation. It also means something you’ve traded before with which you are comfortable.

Once you know what it is, you can start looking for stocks that exhibit that pattern. One of the few advantages of a private trader over an institutional one is that we can trade or not trade when we like. We have the luxury of being free to wait for excellent setups. Unfortunately, most of us, in our eagerness to trade, throw away this amazing advantage. I’ve added the question “Is this an A-trade?” to my Tradebill, a trade management form.

Whenever I see a potential trade, I ask myself this question. If the answer is “yes,” I start calculating risk management, position sizing, and planning my entry. If the answer is “no,” I turn the page and go looking for another pick.  No matter how grand an idea or a stock tip, I will not trade it unless it fits into one of my three strategies. Ideas come and go, fly or flop—but strategies stay and grow better with age, as you learn how they perform under various market conditions.

Gradually, you may develop new strategies and drop others. You can see that the ones I use are numbered 1, 4, and 7. The rest of the numbers were strategies I stopped using. Your system can be very mechanical or quite general, with just a few key principles, like my Triple Screen. Either way, you must know what your “A-trade” looks like before you plan your next trade.

I’ll walk you through one of my strategies, but remember that you don’t have to copy it. The way we trade is as personal as handwriting. Define a strategy that feels comfortable to you, test it, and then find a chart that perfectly represents it. Print that chart and post it on a wall near your trading desk. Now you can search for trades that look the way that chart looked on the day you entered that trade.

FIGURE  SLB daily with 13- and 26-day EMAs and a 6% envelope. Impulse system with MACD-Histogram 12-26-9. 

In the next section, on trade planning, you’ll see how to use a form I named Tradebill to make trading decisions more objective. Every trade has several parameters, and it’s easy to overlook some of them in the heat of action. Just as a pilot goes through a preflight checklist, a trader needs to check his list before deciding to place an order.

Scanning for Possible Trades

There are thousands of stocks out there, and in the days and weeks ahead, some will rise, others fall, and some will fluctuate. Each stock will make money for traders whose systems are in gear with it—and lose money for the rest. Developing a trading system or a strategy must come before scanning. If you don’t have a clearly defined strategy, what will you scan for?!

Begin by developing a system that you trust. Once you have it, looking for trading candidates will become quite logical and straightforward. Looking at your list of candidates, the first question about any pick will be “Is this an A-trade?” In other words, is this pick close to your ideal pattern? If the answer is “yes,” you may start working up a trade.

Scanning means reviewing a group of trading vehicles and zooming in on trading candidates. Your scanning can be visual or computerized: you may flip through multiple charts, taking a quick glance at each, or else have your computer run through that list and flag stocks whose patterns appeal to you. To repeat, defining a pattern you trust must be your first step, scanning a more distant second.

Be sure to have realistic expectations for scanning. No scan can find you the needle in a haystack—the one and only gem to trade. What a good scan does is bring up a group of candidates on which to focus your attention. You can make that group bigger or smaller by loosening or tightening scan parameters. A scan is a time saver that delivers potential candidates; it is not a piece a magic to free you from the necessity of working up your picks.

Begin by describing what stocks you want to find. For example, if you’re a trend-follower, but don’t like chasing stocks, you may design a scan to find stocks whose moving average is rising but the latest price is only a small percentage above that average. You can write a scan yourself or hire someone to do it for you—there are programmers who offer this service. The raw list of stocks to be scanned can be as small as a few dozen or as large as the S&P 500, or even Russell 2,000.

I like looking for trading candidates on weekends, and depending on how much time I have, take one of the two approaches—one lazy and the other hardworking.  The lazy way, when my time is limited, is to review Spikers’ picks for the week ahead. Spikers are the elite members, and I figure that among a dozen picks by super-smart traders who compete for the best pick of the week there ought to be a stock or two for me to piggyback. I examine those picks, while adding my market opinion to the mix. Depending on my outlook for the week ahead, I focus primarily on long or short candidates.

The hard-working way consists of dropping all 500 components of the S&P 500 into my software and running a scan for potential MACD divergences. I’ve seen many divergence scans, but never a reliable one—they all delivered too many false positives and missed many good divergences. Then I realized that a divergence was “an analog pattern”—clearly visible to a naked eye but hard to pick with digital processing. I turned to John Bruns, who built me a semiautomatic MACD divergence scanner. Instead of looking for divergences, it scans for patterns that precede divergences and delivers the list of candidates to watch in the days ahead.

Running my MACD divergence semiautomatic scan over the weekly and daily charts of all 500 components of the S&P 500 takes only a minute, but the real work begins when I review the lists of bullish and bearish candidates delivered by this scan. First, I compare the sizes of bullish and bearish lists. For example, for several weeks prior to writing this chapter, my scan for bullish divergences among the components of the S&P 500 produced four to five candidates, while the scan for potential bearish divergences returned between 70 and 80 stocks.

This great imbalance indicated that the market was perched at the edge of a cliff and I needed to find some shorts for the coming downturn. I prune my weekly list of trading candidates down to five or six picks that show the most attractive patterns and the best reward to risk ratios. These are the stocks that I’ll aim to trade during the week. I have friends who can juggle twenty stocks at once—this can be done, but not by me, and every serious trader must know his limitations.

FIGURE  WFM daily with 13- and 26-day EMAs. Impulse system with MACD-Histogram 12-26-9. Red dots—potential or actual bearish divergences. Green dots—potential or actual bullish divergences.

Another “hardworking way” of finding trade candidates involves scanning stock industry groups. For example, if I think that gold is approaching an important bottom, I’ll pull up the list of all 52 gold stocks and 14 silver stocks that are listed at this timeand look for buying candidates. While doing that, I’ll keep in mind my SLB—I want to find stocks whose patterns look close to my ideal. If you’re going to scan a large number of stocks, it pays to add some negative rules.

For example, you may want to omit stocks whose average daily volume is below half a million or even a million shares. Their charts tend to be more ragged and their slippage worse than in more actively traded stocks. You may want to exclude expensive stocks from your scans for buying candidates and cheap stocks from your scans for shorting candidates. Choosing at what levels to place your price filters is a matter of personal choice. This is why scanning is best left for experienced traders. Learn to fish with just a few lines in the water before casting a broad net.


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