[DbPhoenix]

Given the questions raised here and in the chat room, I've excerpted portions of what Wyckoff has to say about stops. These are from his original course. If some of this sounds familiar, remember that Wyckoff was among the first to address these issues.

STOP ORDERS (Sect. 23M)

(Excerpt)

The first rule in successful trading and investing is: Cut losses short.

First, never make a commitment for investment or speculation purposes until you have decided, in advance, where the danger point exists in that stock. Second, calculate the possibilities for profit if the stock should confirm your judgment by moving in your favor. Third, determine whether the indicated probable profit outbalances the indicated risk by at least three to one. Fourth, place a stop order (under the danger point on a long commitment and above it on a short sale) the moment your buying or selling order is consummated.

Should you have a stock under observation and believe it affords a logical buying or selling opportunity, have patience to wait until it works into a position where it meets the first three conditions above named before you make your purchase, (or sale if you contemplate selling it short). Or, if these conditions cannot be met, look around for another opportunity where they do exist. In other words, test the validity of any proposed commitment by noting, in advance, where your stop order must be placed so that you will always be operating with the odds at least 3 (or more) to 1 in your favor. It pays to wait for these opportunities.

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You decide in advance that you will risk just so much on your judgment that a commitment will be profitable, and you are out automatically when you are wrong. With good judgment, you are not likely to be wrong three times in a row. But assume this does happen and you are using stops which cut your losses to an average of 2 points on each trade. You still have capital intact to take the fourth position on which you will need to make only 8 points to come out ahead of the game. But if, on your first trade you let a loss run to 10 points or more because you failed to use a stop order, it may take only the one venture to tie up your account and put you out of business; or at best, you will be a long time getting back on your feet.

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Stop orders are used:

(1) To limit risk
(2) To reduce risk
(3) To insure profits
(4) To begin new trades at prices above the present market.

Stop orders are used to limit risk, as already explained, by placing a stop order immediately, as soon as a commitment is made.

Stop orders are used to reduce risk when the action of the stock enables you to move the stop closer to the market price than it was originally. If you have an opportunity to do this without jeopardizing your trade, it should be done. It is better to risk 1 point than 2 or 3, but do not be too hasty in moving the stop up or down. Watch for the support and resistance points to develop so that you can use these as guides when placing or changing your stop orders.

Of course when you can move your stop order to cover cost or selling price and commissions, there is no risk; your expectancy is then 100% of the indicated profit.

Stop orders cannot always be executed exactly at the stop price. Bear this in mind: A stop order is an order to buy or sell at the market when the stop price is reached. So never blame your broker if he cannot get you out exactly at the price at which you have placed your stop.

Stop orders are used to insure profits. One can never tell when a contrary move in the market will wipe out a paper profit. Rarely should a profit of even 3 points be allowed to run into a loss. This applies to investment, as well as to trading commitments.

An initial move of 10 points in your favor, if it started from the point of accumulation or distribution, will usually be followed by a contrary movement of 3 to 5 points. You must allow for that contrary movement in judging where to place your stop. The greater the initial move, the greater the expected rally or reaction. Even though you expect a probable move of 20 points in your favor, make sure that you nail some of the 10 points you have on paper. The move may have been just a flash in the pan. A rise from 60 to 70 is no guarantee that the next move will not be down to 50.

Stop orders may be used to begin new trades above [and] below the present market. However, it is best that you do not undertake to employ stop orders for this purpose unless you have had a great deal of experience and know exactly what you are about. Otherwise, there is a danger you will be whipsawed.

A buy stop would be used to begin a new trade on the long side above the present market.

A sell stop would be used to begin a new trade on the short side below the present market.

A buying stop is used under conditions where you have reasons to believe that the fulfillment of a required rally indication would be likely to initiate a further rise or the beginning of an important advance with no further material reaction; and where it appears that unless you catch the initial move immediately on the day the required indication appears, you might miss it or be compelled to pay a higher price by waiting. These conditions may prevail: (1) when a stock is near the end of a period of accumulation or absorption and seems ready to step on the springboard, (2) When a stock is on the hinge, that is, at a dead center. (3) When a stock has been in a trading range and it appears that if it can overcome previous resistance it will go into a definite mark up.

The disadvantage of this procedure is that since your risk begins the moment a new trade is made for you, you must place a new stop order immediately to protect your purchase, just as you place a fire insurance policy on a house when you buy it.

A selling stop is the reverse of a buy stop and is used to begin a new trade on the short side when you have reason to believe that a reaction to a certain price would be likely to signal the beginning of a further down swing or the beginning of a large decline, with no further material rally.

The advantage of a selling stop is the same as in the case of a buying stop. You use it under conditions where you believe that the indicated down move is not likely to start unless and until a certain price is reached. And, when that price is reached, you figure that the decline will continue rapidly so that it is better to act on what is the equivalent of an automatic selling order than to risk a chance that you might miss catching the beginning of the move, or risk having the price slide rapidly away from you if you should wait for the required indication to be fulfilled.

The disadvantage of such a stop is the same as in the case of the buy stop.

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Arbitrary stops of 2, 3 or more points should be used only when the tape or the chart does not show a support or resistance level, or a support or resistance point, nor otherwise give an indication as to where your stop might be logically placed.

The number of points you will risk in placing a stop should also be governed by the type of operation you are engaged in. Thus, in short swing trading operations where you may be trying for the 3 to 5 point moves, your initial stop must be placed much closer to the danger points and should be moved to reduce risk more quickly than in the case of commitments made for the intermediate swings of 10 to 20 or more points. The difference is that in the case of short swing trades, you are trying for smaller indicated profits and a more rapid turnover of capital; hence to keep the proper limitation of risk you must crowd your stops closer than in the case of long swing operations where you wish to allow for normal corrective rallies and reactions, or changes of stride, without being kicked out of your position on minor reversals of an established trend. All of which sums up into saying: In handling stops, be influenced by the purpose for which you made your commitment originally and adjust your stops thereafter in accordance with the subsequent behavior of the stock and the market as a whole.

Always keep in mind that: Stop orders should NEVER be changed so that your risk is increased. All changes should be made for the purpose of reducing risk or eliminating risk or making sure of part of your paper profits.

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After a stock has moved well away from the point at which you took a long or a short position, you must remember that the further it moves, the nearer it is coming to the reactionary or rallying point, or the turning point for a swing in the opposite direction. The more it goes in your favor and the more it approaches the point (objective) where, you estimate, it should rally or react or turn completely, the closer your stop should be to the market price.

If you calculate that there should be a 15 point move in your favor, do not hold out for the last point. If you are 10 or 12 points to the good on paper, crowd the stop order right behind the price when you see indications of hesitation. The more the stock hesitates and seems ready to reverse, the closer your stop should be.

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Of course, even the very best judgment in making commitments and the best logic in handling stops cannot prevent having them caught at awkward places. In such instances, that is, where you see you have been stopped out prematurely, it pays to re-establish your original position if you find that the action of your stock subsequently justifies going right back into it. But you must set your stop on the re-established commitment just as if it were an entirely new position and without regard to the price at which you previously went in or were stopped out.

There are three reasons for the too frequent catching of stops:

(1) Starting trades too soon. This may be the result of impatience - hence poor timing or failure to wait for
reasonably conclusive indications - or failure to observe the principles set forth in paragraphs [1 and 2, top of the page].

(2) Bucking the trend.

(3) Improperly placing and adjusting your stops.

If you find your stops are being caught frequently, go over your trades carefully to determine whether the fault may be attributed to any or all of the above causes. Then review the instructions herein and all preceding references to stop orders so you may discover your errors and thus avoid repeating the same mistakes in the future.

Should it appear that your commitments are started right and your stops are reasonably well placed, then the frequent catching of stops should be taken as a warning that you are not operating in harmony with the trend of the market. Then, if you persist in selling stocks short in a rising market you are bound to expose your stops to the danger of being touched off on bulges. Conversely, if you repeatedly buy on what you believe to be reactions only to discover that your stops are consistently caught, this should be taken as an indication that you are operating on the wrong side of the market - the trend is down and those presumed “reactions” in reality are waves of liquidation. Such errors of judgment sometimes lead students to abandon the use of stops. Nothing could be more dangerous.

[imahippi]

Some people say they use mental stops.
I think this is my goal but I find as a beginner I have to put the stop order in right after the buy or I often fold.
Until I develop better discipline I have to do this. It is the primitive form of discipline for me.
I look for the point where---to me--- the trend that I am hoping to capitalize on is broken.

In my trading I am working on being more agile, that is , jumping out quickly and watching and then getting right back in. This is not easy for me.
Also, getting in as close as possible to the test of support or resistance.

[Head2k]

Originally Posted by imahippi »

Some people say they use mental stops.
I think this is my goal but I find as a beginner I have to put the stop order in right after the buy or I often fold.
Until I develop better discipline I have to do this. It is the primitive form of discipline for me.

It is also form of safety protection. If broker, your computer, internet connection or electricity goes down, then the stop in your head won't help you much.

[cowseathay]

Thank you Db. It's amazing to think that the same problems that plague traders today was dealt with so eloquently by Wyckoff almost a 100 years ago.

By the way, you had mentioned in chat that you learned to use buy/sell stops to enter trades from Teresa Lo, but here it seems Wyckoff had suggested the same thing. It's interesting to know that it came from Wyckoff.

[DbPhoenix]

Originally Posted by cowseathay »

Thank you Db. It's amazing to think that the same problems that plague traders today was dealt with so eloquently by Wyckoff almost a 100 years ago.

By the way, you had mentioned in chat that you learned to use buy/sell stops to enter trades from Teresa Lo, but here it seems Wyckoff had suggested the same thing. It's interesting to know that it came from Wyckoff.

So does a great deal else. Teresa, however, actually gives credit where credit is due, whereas most others like to pretend that whatever they're selling is original.

[BrunoHammerstorm]

Great post as always DB,

I'm glad that traders are still educating traders. It's a pleasant change from constant vendor interruption and interference.

[jim2000]

Thanks for the words of wisdom.

It's funny how once one becomes more experienced as a trader one can read a post such as this and really understand it and say hey, now I get it! Now I understand! Almost every single word is important.

It only took hundreds of trades of not setting stops, and hundreds of times realizing what could have been. I am lucky to still have an account.

You truly do a great service to the trading community. Thank You.

[mjackson]

To use mental stops one has to be disciplined and confident...