Showing posts with label the-new-trading-for-a-living-free. Show all posts
Showing posts with label the-new-trading-for-a-living-free. Show all posts

Sunday, September 15, 2019




There is no free lunch. As with so many other things, either you’re going to pay up front or you’re going to pay on the back end for being disorganized, and unfortunately, when you pay on the way out it’s always more expensive...” writes Andrew J. Mellon in Unstuff Your Life. The market is perversely inconsistent in dishing out rewards and punishments. There is always a chance that a poorly planned trade may bring profits, while a well-planned and carefully executed trade may end in a loss.

This random reinforcement subverts our discipline and encourages sloppy trading. Good record-keeping is the best tool for developing and maintaining discipline. It ties together psychology, market analysis, and risk management. Whenever I teach a class, I say: “Show me a trader with good records, and I’ll show you a good trader.” Writing down your trade plans will ensure that you don’t miss any essential market factors. 

Good record-keeping will save you from stumbling into impulsive trades. Trading discipline is similar to weight control, which is very hard for most people. If you don’t know what you weigh today and whether the curve of your weight is rising or falling, how can you control it? Losing weight begins with standing naked on a scale in the morning and writing down your weight for that day. We all make mistakes, but if you keep reviewing your records and reflecting on past mistakes, you’ll be unlikely to repeat them.

Good record-keeping will turn you into your own teacher and do wonders for your account equity. A quick read will not make you a disciplined trader. You’ll have to invest hours in doing homework and accept the pain of having your stops hit. The work comes first, the rewards later. As your account grows, you’ll experience a wonderful feeling of accomplishment. Let’s review the three key components of record-keeping:
  1. Discipline begins with doing your homework.
  2. Discipline is reinforced by writing down your trade plans.
  3. Discipline culminates in executing those plans and completing trade records.

Please feel free to personalize all of these documents. The markets are huge and diverse, and there is no “one size fits all” system of analysis, trading, and record keeping. The basic principles are in this book, but the way you implement them can be your own.

Your Daily Homework

When you wake up in the morning and know that you need to be at the office in an hour, you don’t spend time planning every little step. You follow an established routine: get out of bed, wash, get dressed, have breakfast, get in a car, etc. This routine puts you in the groove for the day ahead, leaving your mind free for strategic thinking. By the time you arrive at the office, you’re ready to face the day. It pays to have a morning routine for the market: a sequence of steps for touching base with the key factors that may dominate today’s trading. This routine should put you in gear with the market before the opening bell, making you alert and ready to act. 

I use a spreadsheet for my pre-open routine. The person who gave me this idea was Max Larsen, a money manager in Ohio. I’ve changed Max’s spreadsheet: my current version is numbered 3.7, reflecting two major revisions and a handful of lesser ones. It is based on how I view the markets, while its imbedded links help me reach various websites for the information I want. My homework spreadsheet is a work in progress, as I keep adding and deleting lines. If you start using it, I’m sure that you’ll modify it to suit your preferences. 

After filling out this spreadsheet, I turn to my open trades. I review their stops and profit targets, making any adjustments for the coming day if necessary. Then, if I’m planning to trade today, I review my short list of candidates, focusing on planned entries, targets, and stops. Now I am in gear with the market, ready to place orders. I do this homework even if I know that I will not be able to trade during the day, for example when traveling. This discipline is just like washing and dressing in the morning, even on the days when you don’t plan to go to the office.

FIGURE  Daily homework spreadsheet. 

Are You Ready to Trade Today?

There are times when you feel in gear with the market, but at other times you’re out of touch. Your mood, health, and time pressures influence your ability to trade. For example, imagine trading while suffering from a toothache. You can’t fully concentrate on the market and should be calling your dentist, not your broker. This is why each morning, I take a 30-second psychological self-test for an objective rating of my readiness to trade. 

The first person I saw use a self-test was Bob Bleczinski, a former Spiker. He may have posted his test online because in 2011, I saw SpikeTrade member Erin Bruce present her self-test at that year’s reunion. The questions she asked herself were completely different, but the format looked like Bob’s. I modified Erin’s self-test to fit my personality and take it every day before the market opens. Any self-test must be short and specific. Mine has only five questions, and each of them can have only one of three answers: yes, no, or so-so

If you start using this test, you’ll probably modify it to fit your personality and ask the questions that are most important to you. A zero rating on some of the questions also warns me not to trade. If I haven’t done my trade planning or if my schedule is very booked up, this would be a bad day to trade—better stand aside or place only exit orders. You, your mind, your mood, and your personality are the essential components of trading. This is why a quick self-test helps you see whether you should be trading today.

FIGURE  “Am I ready to trade?” self-test. 

Creating and Scoring Trade Plans

A plan for any trade must specify what strategy you’ll use. It must prompt you to check the dates of earnings and dividends or contract rollovers, in order to save you from being blindsided by predictable news. It must spell out your planned entry, target, and stop as well as your trade size. Writing down a trade plan makes it real. Once you enter a trade and your equity starts fluctuating, you may feel stressed and forget to perform certain tasks.

The plan you write prior to entering a trade becomes your island of sanity and stability in the middle of a storm; it helps ensure that you don’t overlook anything essential. A really good plan will include a scale for measuring its quality. This objective rating, which we’ll discuss below, takes less than a minute, but it encourages you to implement only those plans that have a higher likelihood of success. It prompts you to drop marginal plans and not chase borderline trade ideas.

While all my records are in electronic format, I like having my trade plans on paper. I use preprinted forms that I named Tradebills, similar to waybills that come with the packages we order online. When a company sends you a product, it comes with a waybill that shows the name of the product, its quantity, your address, the mode of delivery, rules for returns, and other essential facts. My trades are accompanied by tradebills from the planning stage to the closing day.

I have two separate tradebills for each trading system, one for buying and another for shorting. Here we’ll review a tradebill for one of my favorite strategies. You can use it as a starting point for developing your own tradebill. Whenever a potential trade catches my eye, I decide which system it fits and then pick up the appropriate blank tradebill. Right there, if a seemingly attractive trade fits no trading system, then there is no trade. Having decided on a system, I write down the date and the ticker symbol, and then score that potential trade, as shown below.

If the score is high enough, I proceed to complete my trade plan; otherwise, I toss that sheet of paper into a wastebasket and go looking for other trades. Wherever I go, I carry my tradebills for open trades. If I’m at my desk, they are next to my keyboard. If I go out during the day and bring my laptop, I put those tradebills between the keyboard and the screen, so they’ll be the first thing to see when I open up my laptop.

Having written down my trade plans for years, I gradually developed a method for scoring them before making a go/no-go decision. My habit of scoring plans was reinforced when I read Thinking, Fast and Slow by Prof. Daniel Kahneman. This book on decision making by a behavioral economist and a Nobel Prize winner underscored the value of simple scoring systems—they make our decisions more rational and less impulsive.

Scoring Your Trade Plans (a Trade Apgar)

Among the examples in Prof. Kahneman’s book was his description of the work of Dr. Virginia Apgar (1909–1974), a pediatric anesthesiologist at Columbia University. She is widely credited with saving countless lives. Doctors and nurses worldwide use the Apgar scale for deciding which newborns require immediate medical care.

Most babies are born normal; some have complications, while others are at risk of dying. Prior to Dr. Apgar, doctors and nurses used clinical judgment to tell those groups apart, and their mistakes contributed to infant mortality. Dr. Apgar’s scoring system made their decisions objective. The Apgar score summarizes answers to five simple questions. Each newborn is rated on its pulse, breathing, muscle tone, response to a pinch, and skin color. 

A good response to any question earns two points, poor zero, or one for an in-between. The test is generally done at one and five minutes after birth. Total scores of seven and above are considered normal, 4 to 6 fairly low, and less than 4 critically low. Babies with a good score are safe to put into general care, while those with low Apgar scores require immediate medical attention. The entire decision-making process, focusing on whom to treat aggressively, is quick and objective. Dr. Apgar’s simple scoring system has improved infant survival rates around the world.

After reading Prof. Kahneman’s book, I renamed my scoring system the “trade Apgar.” It helps me decide which of my trade ideas are strong and healthy or sickly and weak. Of course, as a trader, my actions are completely opposite to those of a pediatrician. A doctor focuses on the sickest kids, to help them survive. As a trader, I focus on the healthiest ideas and trash the rest. Before I show you my Trade Apgar, a word of caution: the scoring method you’re about to see is designed for one system—my “false breakout with a divergence” strategy. 

All other systems will require a different test. Use my Trade Apgar as a starting point for developing a test for your own system. For example, I recently gave the file of my Trade Apgar to a professional option writer who consulted with me. He loved the idea of a written test, which reduced impulsivity, one of his key problems. Within a few weeks, he showed me his own Trade Apgar, which greatly differed from mine. He replaced one of my indicators with his favorite RSI and Stochastic and added questions directly relevant only to option writing. I was happy to see that he was trading more profitably.

A Trade Apgar demands clear answers to five questions that go the heart of a trading strategy. As you develop a Trade Apgar for your own strategy, I suggest keeping the number of questions down to five and rating your answers on a zero/one/two point scale. Simplicity makes this test more objective, practical, and quick. While looking at a potential trade, I take a blank tradebill from a stack and circle my answers to its five questions. A circle in the red column earns a zero, in the yellow column one point, and in the green column two points.

I write down each number in the score box and add up the five lines. Also, if I circle the red column, I may write in the box next to it at what price the answer will change to a more favorable yellow or green. That will raise the plan’s score, allowing me to enter a trade at that level. It takes less than a minute to generate a Trade Apgar for any stock. I want to trade only healthy ideas whose score is 7 or higher, and not a single line rated zero. 

FIGURE  Trade Apgar for going long, using a strategy of “false breakout with a divergence.”

If the score is 7 or higher, I go on to complete my trade plan. I establish my entry, target, and stop, decide what size to trade, etc. Trade Apgars provide objective ratings for potential trades. With thousands of trading vehicles available to us, there is no need to waste energy on poor candidates. Use a Trade Apgar to help you zoom in on the best prospects.

Using a Tradebill

Once you become interested in a stock and a Trade Apgar confirms your idea for a trade, completing a tradebill will help you focus on the key aspects of that trade. Let’s review a tradebill for long positions. I designed my Tradebills in PowerPoint, fitting two to a page. 

FIGURE  Trade Apgar for shorting, using strategy of “divergence with a false breakout.”

FIGURE  Tradebill for going long, using the strategy “divergence with a false breakout.” 

I always keep some blanks handy, but don’t preprint too many because I keep tweaking these forms. My tradebill for short trades is the same, except for a different Trade Apgar. When you start developing your own tradebills, you may want to copy sections 1, 3, and 4, but develop your own section 2—the Trade Apgar for your own system or strategy.

Trade Journal

Memory is the cornerstone of civilized life. It allows us to learn from our successes and even more from our failures. Keeping a diary of your trades will help you grow and become a better trader. Keeping detailed trade records feels burdensome—but that’s what serious traders do. They lived in different countries, traded different markets, and used different methods—but all kept excellent records.

While finishing the manuscript, I realized that our interview had been incomplete and I needed to ask additional questions about her trades. A year later, on another visit to California where she lived, I asked to meet again. I assumed she’d show me some recent trades, but she went to a filing cabinet and pulled out a folder with all her trades for the week of my previous visit.

We completed our interview by reviewing her charts from a year ago as if those trades were made yesterday. A bull market was in full swing, she was doing great, but still worked to improve her performance. Her detailed diary was her self-improvement tool. Let your diary entries serve as your “extra-cranial memory,” a tool for building the structure of success.

For years, I struggled with developing a record-keeping system that would be easy to update and analyze. In the beginning, I kept the diary of my trades in a paper journal, gluing in chart printouts and marking them up—I still keep one of those antiques next to my trading desk. Later I kept my diary in Word, and then in Outlook.

Finally, in 2012, Kerry Lovvorn and I created a web-based Trade JournalThis Trade Journal is a joy to keep, and both Kerry and I use it for all our trade diaries. Our Trade Journal is available to all, and its use is free (up to a limit). The journals are online, password protected, and absolutely private—although SpikeTrade members have an option of sharing their trade journals for selected trades.

Even if you prefer to build your own, look at it to see what must be included in your own record-keeping system. The Trade Journal is designed to make your record-keeping simple and logical, helping you plan, document, and learn from your trades. We have already reviewed several sections of the Trade Journal.

FIGURE  Trade Journal (a partial view). 

Most of us quickly forget past trades, but the Trade Journal prompts you to return to them. The trades you entered and exited at the hard right edge of the chart are now in the middle of that chart, where you can re-examine your decisions and learn how to improve them.

Three Benefits

Keeping a trade journal delivers three major benefits. One is immediate—a greater sense of order. The second comes a month or two later, when you start reviewing your closed trades. Finally, after you accumulate dozens of records, you’ll have several ways to analyze them and learn from your equity curves. A Sense of Order and Structure comes from documenting the plan, the entry, and the exit for each trade.

Where exactly will you enter, what is your target, where will you place your stop? Defining and writing down those numbers will steer you towards disciplined trading. You’ll become less likely to slip into an impulsive buy, overstay a profitable trade, or let a loss snowball without a stop. Filling out risk management numbers will give you a handle on trade sizing. Documenting exits will make you face your trade grades.

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

Reviewing Every Trade a month or two after your exit is one of the best learning experiences you can have. Trading signals that may have appeared vague and uncertain at the right edge of a chart become crystal clear when you view them in the middle of your screen. Returning to your past trades and adding an “after the trade” chart makes you reevaluate your decisions. Now you can clearly see what you did right or wrong. Your journal will be teaching you priceless lessons.

I make my strategic decisions on the weekly charts, tactical on the dailies. Since my daily charts are formatted to show five to six months of data, once a month I spend a few hours reviewing trades that I closed two months ago. For example, at the end of March or in the beginning of April, I’ll review all trades that I closed out in January. I’ll pull up their current charts, mark my entries and exits with arrows, and write a comment on every trade.

Such reviews teach you what’s right with your trading, and what needs to be changed. Soon after I started doing my “two months later” reviews, I became aware of two problems with my exits. I noticed that my stops were a bit tight and that helped me figure out that by slightly increasing the amount of risk, I could substantially reduce the number of whipsaws and come out ahead. 

FIGURE  MCP daily with 13- and 26-day EMAs and a 16% channel. Impulse system with MACD-Histogram 12-26-9.

I also noticed that while my short-term swing trades tended to be good, I often missed bigger trends that emerged from those short-term moves. I used that knowledge to adjust my methods going forward. Reviewing Your Equity Curve is essential because only a rising curve certifies you as a successful trader. If your equity curve is in a downtrend, your system may be at fault, or your risk management poor, or your discipline lacking—whatever it is, you must track it down and solve that problem.

Still, a combined equity curve for all your trades and accounts is a pretty crude tool. The Trade Journal allows you to zoom in and trace your equity curves for specific markets, strategies, and exit tactics. For example, I can run separate equity curves for longs and shorts, for different strategies and exits, and even for sources of my trade ideas. Believe me: once you see an equity curve for exits marked “Couldn’t stand the pain,” you’ll never trade without stops!

Saturday, September 14, 2019




Will you be buying stocks that break out to new highs? Shorting double tops? Buying pullbacks? Looking for trend reversals? Those approaches differ from each other, and you can make or lose money with each of them. You need to select a method that makes sense to you and feels emotionally comfortable. Choose what appeals to you, what matches your abilities and temperament. There is no such thing as generic trading, any more than there is a generic sport. To find good trades, you need to define the pattern you want to trade. 

Prior to using any scan, you need to have a crystal-clear picture of what it should look for. Develop your system, and test it with a series of small trades to make sure you have the discipline to follow your signals. You have to feel certain that you’ll trade the pattern you’ve identified when you see it. Different styles of trading call for different entry techniques, different methods of setting stops and profit targets, and very different scans. Still, there are several key principles that apply to all systems.

How to Set Profit Targets: “Enough” Is the Power Word

Setting profit targets for your trades is like asking about pay and benefits when applying for a job. You may end up earning more or less than expected, but you need to have an idea of what to expect. Write down your entry level, profit target, and stop for every planned trade in order to compare your risk and reward. Your potential reward should be at least twice as big as your risk. It seldom pays to risk a dollar to make a dollar—you might as well bet on color at a roulette table.Having a realistic profit target and a firm stop will help you make a go/no-go decision for any trade.

Early in my trading career I didn’t think of profit targets. If anybody asked me about them, I’d answer that I didn’t want to limit my profit potential. Today, I would laugh at such an answer. A beginner without a clear target price will feel increasingly happy as his stock goes up and more despondent as it grinds down. His emotions will prime him to act at the worst possible times: continue to hold and add to his longs at the top and sell out in disgust near the bottom.

FIGURE  VRSN with 13- and 26-day EMAs, the Impulse system, and a 4% envelope. MACD 12-26-9.

When calculating a trade’s profit potential, we run into a paradox. The longer your expected holding period, the bigger the profit potential. A stock can rally much more in a month than in a week. On the other hand, the longer your holding period, the higher the level of uncertainty. Technical analysis can be quite reliable for shorter-term moves, but many unpleasant surprises will occur in the longer run. The holding period for position trades or investments is measured in months, sometimes years. 

We may hold a swing trade for a few days, sometimes weeks. The expected duration of a day-trade is measured in minutes, rarely hours. Moving averages and channels help set profit targets for swing trades. They also work for day-trades; only there you need to pay more attention to oscillators and exit at the first sign of a divergence against your trade. Profit targets in position trading are usually set at previous support and resistance levels.

FIGURE  EGO 25- and 5-minute charts with 13- and 26-bar EMAs, the Impulse system, and Autoenvelope. MACD 12-26-9. 

The three targets mentioned above—moving averages, channels, and support/resistance levels—are fairly modest. They don’t have you shooting for the moon, but are realistic. Keep in mind that “enough” is a power word—in life as well as trading. It puts you in control, and by getting “enough” in one trade after another, you’ll achieve excellent results over time.

How to define “enough”? I believe that moving averages and envelopes, along with recent support and resistance levels can show us what would be “enough” for any given trade. Let me illustrate this with several examples: one a swing trade, another a day-trade, and the third a long-term investment. VRSN was a fairly common example of a modest swing trade: entering near one of the channel lines and taking profits in the value zone between the two moving averages. This isn’t elephant hunting; this is rabbit hunting, a much more reliable activity.

The EGO day-trade buying a pullback into the value zone during an uptrend, with a profit target at the upper channel line. I used an oscillator to speed up my exit when the market wouldn’t let me exit at the initial target. “Fallen angels” is the name of a scan I use to look for possible investment candidates. It marks stocks that have fallen over 90% from their peaks, stopped declining, bottomed out, and slowly began to rise. A stock that had lost 90% of its value has every right to die, but if it chooses to live, it’s likely to rally.

FIGURE  IGOI with 13- and 26-day EMAs, the Impulse system, and a 4% envelope. MACD 12-26-9.

The best time to look for “fallen angels” is when a bear market starts showing signs of bottoming. That’s when you find many candidates that survived bear attacks and are starting to get up from the floor. This example shows an old bull market darling IGOI that got badly mauled but stopped declining and began to rise. The weekly chart shows two prior attempts to return to the multiyear peak area.Each of those rallies retraced just about half of the previous bear market. Is this going to be an easy trade? Far from it. 

First of all, the latest bottom was near $2, and if you place your stop there, your risk per share will be quite high, and you’ll have to reduce trade size. Also, the expected rally may take anywhere from a few months to several years to get going. Are you prepared to wait that long, with your capital tied up? Last but not least, the volume of this stock is low. It will rise if prices rally, but if the rally fizzles out, selling will not be easy. Taking all these factors into account, you can see how hard it is to buy for the long haul.

How to Set Stops: Say No to Wishful Thinking

A trade without a stop is a gamble. If you’re after thrills, better go to a real casino. Take a trip to Macao, Las Vegas, or Atlantic City, where a gambling house will serve you free drinks and may even comp you a room while you’re having fun. Gamblers who lose money on Wall Street receive no freebies.

Stops are a must for long-term survival and success, but most of us feel a great emotional reluctance to use them. The market reinforces our bad habits by training us not to use stops. We all have been through this unpleasant experience: you buy a stock and set a stop that gets hit and you exit with a loss—only to see your stock reverse and rally just as you originally expected. Had you held that stock without a stop, you would’ve profited instead of losing. Getting repeatedly whipsawed like that makes you feel disgusted with stops.

After several such events, you start trading without stops, and it works beautifully for a while. There are no more whipsaws. When a trade doesn’t work well, you get out of it without a stop—you have enough discipline. This happy ride ends after a large trade starts going bad. You keep waiting for it to rally a bit and give you a better exit, but it keeps sinking. As the days go by, it inflicts more and more damage on your account—you’re being chewed up by a shark. Soon enough your survival is in danger, and your confidence is shattered.

While you trade without stops, the sharks circling the perimeter of every account grow bigger and meaner. If you trade without stops, a shark bite is only a question of time. Yes, stops are a pain—but using them is a lesser evil than trading without them. This reminds me of what Winston Churchill said about democracy: “It is the worst form of government except all the others that have been tried.” What should we do? I suggest accepting the irritation and the pain of stops but focusing on making them more logical and less unpleasant.

Place Stops outside the Zone of “Market Noise”

Put a stop too close and it’ll get whacked by some meaningless intraday swing. Put it too far, and you’ll have very skimpy protection. To borrow an engineering concept, all market moves have two components: signal and noise. The signal is the trend of your stock. When the trend is up, we can define noise as that part of each day’s range that protrudes below the previous day’s low. When the trend is down, we can define noise as that part of each day’s range that protrudes above the previous day’s high.

SafeZone stops are described in detail in Come into My Trading Room. They measure market noise and place stops at a multiple of noise level away from the market. In brief, use the slope of a 22-day EMA to define the trend. If the trend is up, mark all downside penetrations of the EMA during the look-back period (10 to 20 days), add their depths, and divide the sum by the number of penetrations. 

This gives you the Average Downside Penetration for the selected look-back period. It reflects the average level of noise in the current uptrend. You want to place your stops farther away from the market than the average level of noise. That’s why you need to multiply an average downside penetration by a factor of two or greater. Placing your stop any closer would be self-defeating.

When the trend, as defined by the EMA slope, is down, we calculate SafeZone on the basis of upside penetrations of the previous bars’ highs. We count each upside penetrations during a selected time window and average that data to find the Average Upside Penetration. We multiply it by a coefficient, starting with 3, and add that to the high of each bar. Shorting near the highs requires wider stops than buying near quiet, sold-out bottoms.

Like all systems and indicators in this book, SafeZone is not a mechanical gadget to replace independent thought. You have to establish the look-back period, the window of time during which SafeZone is calculated. You also need to fine-tune the coefficient by which you multiply the average penetration, so that your stop goes outside the normal noise level. Even when not using SafeZone, you may wish to follow its principle of calculating an average penetration against the trend that you are aiming to trade—and putting your stop well outside the zone of market noise.

Don’t Place Your Stops at Obvious Levels

A recent low that sticks out like a sore thumb from a tight weave of prices draws traders to place stops slightly below that level. The trouble is most people place their stops there, creating a target-rich environment for the running of stops. The market has an uncanny habit of quickly sinking back to those obvious lows and triggering stops before reversing and launching a new rally. Without trying to assign blame for raiding stops, let me suggest several solutions.

It pays to place your stops at non-obvious levels—either closer to the market or deeper below an obvious low. A closer stop will cut your dollar risk but increase the risk of a whipsaw. A deeper stop will help you sidestep some false breakouts, but if it gets hit you’ll lose more. Take your pick. For short-term swing trading, it generally pays to place your stops tighter, while for long-term position trades, you’d be better off with wider stops. Remember “the Iron Triangle of risk control”—a wider stop demands a smaller trade size.

One method I like is Nic’s stop, named after my Australian friend Nic Grove. He invented this method of placing a stop not near the lowest low, but at the second lowest low. The logic is simple—if the market is sliding to its second lowest low, it is almost certain to continue falling and hit the key low, where the bulk of stops cluster. Using Nic’s stop, I get out with a smaller loss and lower slippage than would occur when the markets drop to more visible lows.

The same logic works when shorting—place your Nic’s stop not “a tick above the highest high” but at the level of the second highest high. Let’s review some recent examples of both longs and shorts. You may want to explore several different systems for placing stops, such as Parabolic, SafeZone, and Volatility stops, . You can get fancy or you can stay plain, but keep in mind the most important principles: first, use stops; and second, don’t place them at obvious levels, easily visible to anyone looking at that chart. 

Make your stops a little tighter or wider than average— stay away from the crowd because you don’t want to be an average trader. For the same reason, avoid placing stops at round numbers. If you buy at $80, don’t place a stop at $78 but at $77.94. If you enter a day-trade at $25.60, don’t place a stop at $25.25—move it to $25.22 or even $22.19. Round numbers attract crowds—put your stop a little farther away. Let the crowd take the first hit, and perhaps your own stop will remain untouched.

Another method, popularized by Kerry Lovvorn, is to use Average True Range (ATR) stops. When you enter during a price bar, place your stop at least one ATR away from the extreme of that bar. A two ATR stop is even safer. You can use it as a trailing stop, moving it at every bar. The principle is the same—place your stop outside the zone of market noise.

One of the advantages of using trailing stops is that they gradually reduce the amount of money at risk. Earlier we discussed the concept of “available risk”. As a trade followed by a trailing stop moves in your favor, it gradually frees up available risk, allowing you to make new trades. Even if you don’t use SafeZone or ATR stops, be sure to place stops at some distance from recent prices. 

You don’t want to be like one of those fearful traders who jam their stops so close to current prices that the slightest meaningless fluctuation is certain to hit them. The concept of signal and noise can help you not only place intelligent stops but also find good entries into trades. If you see a stock in a strong trend but don’t like to chase prices, drop down one timeframe. 

FIGURE Daily charts with 13-day EMA, the Impulse system, and MACD-Histogram 12-26-9.

For example, if the weekly trend is up, switch to the daily chart, and you’ll probably see that once every few weeks, it has a pullback below the value zone. Measure the depths of several recent penetrations below the slow EMA to calculate an average penetration. Place a buy order for the day ahead at that distance below the EMA and keep adjusting it every day. You will use a splash of noisy behavior to get a good entry into a trend following trade.

Don’t Let a Winning Trade Turn into a Loss

Never let an open trade that shows a decent paper profit turn into a loss! Before you put on a trade, start planning at what level you’ll begin protecting your profits. For example, if your profit target for that trade is about $1,000, you may decide that a profit of $300 will need to be protected. Once your open profit rises to $300, you’ll move your protective stop to a breakeven level. I call that move “cuffing the trade.”

Soon after moving your stop to breakeven, you’ll need to focus on protecting a portion of your growing paper profit. Decide in advance what percentage you’ll protect. For example, you may decide that once the breakeven stop is in place, you’ll protect a third of your open profit. If the open profit on the trade described above rises to $600, you’ll move up your stop, so that the $200 profit is protected.

FIGURE  S&P 500 and a 20-day New High–New Low Index. 

These levels aren’t set in stone. You may choose different percentages, depending on your level of confidence in a trade and risk tolerance. As a trade moves in your favor, your remaining potential gain begins to shrink, while your risk—the distance to the stop—keeps increasing. To trade is to manage risk. As the reward-to-risk ratio for your winning trades slowly deteriorates, you need to begin reducing your risk. Protecting a portion of your paper profits will keep your reward-to-risk ratio on a more even keel.

Move Your Stop Only in the Direction of Your Trade

You buy a stock and, being a disciplined trader, put a stop underneath. That stock rises, generating nice paper profits, but then it stalls. Next, it sinks a little, then a bit more, and then goes negative, inching towards your stop. As you study the chart, its bottom formation looks good, with a bullish divergence capable of supporting a strong rally. What will you do next?

First of all, learn from your mistake of not having moved up your stop. That stop should have been raised to breakeven a while ago. Failing that, your options have narrowed: take a small loss right away and be ready to reposition later—or continue to hold. Trouble is you feel tempted to go for the third and utterly unplanned choice—to lower your stop, giving your losing trade “more room.”

Don’t do it! Giving a trade “more room” is wishful thinking, pure and simple. It doesn’t belong in the toolkit of a serious trader. Giving “more room” to a losing trade is like telling your kid you’ll take away his car keys if he misbehaves, but then not following through. That’s how you teach him that rules don’t matter and encourage even worse behavior. Standing firm brings better long-term results.

The logical thing to do when a trade starts acting badly is to accept a small loss. Continue to monitor that stock and be ready to buy it again if it bottoms out. Persistence pays, commissions are cheap, and professional traders often take several quick stabs at a trade before it starts running in their favor.