Lessons on Stop Loss

Time flies and it's already a year since I have embarked on trading the US market. It's a small portion of my portfolio as I still deemed it as experimental. My result sheet, as mentioned before, is far from fantastic despite my better trade executions this year. This is because I have downsized my positions and used less CFD (margin) to trade, as a result, my gains are smaller compared to old losses on CFD last year.

Looking back, I would attribute 50% of my gains this year to luck and 50% to discipline. Discipline to wait for the right signal before entering, discipline to set a stop loss and stick to it, discipline to keep the winner and not take profit too early. I would recommend this fantastic read about trading, with useful infographics - Here is a secret why the more you want to earn Million Dollars from trading, the tougher it become (external link)

"Stop Loss lets me sleep with peace of mind." 

- Rainbowcoin (I always hold overnight positions.)

You could read more on what is stop loss from Investopedia and here are some lessons that I have learnt thus far. 

• Limit stop loss determines how much we will lose when we are wrong. On the other hand,  trailing stop determines how much we will gain when we are right. Of course limit stop has its limitations, we shall see in case study below.
• When price rises but volume dwindles, we could set a tighter stop loss and prepare to take the opposite side of the trade.
• In times of higher market volatility, we should set our stop loss and take profit orders wider to prevent getting prematurely stopped out and maximize profit gains on big price swings. In times of low volatility (use 'Envelope' to see) we have to set our stop loss closer to entry price or trail more closely. In protecting gains, we may move the stop loss too close to our point of the entry but it can be dangerous to do so. It can result in the problem of short squeeze when price retraces back and squeezes the amateurs out at very obvious price levels when it could have been a profitable trade. [Reference: 9 Tips That Will Improve Your Risk Management Right Now] - This what I call getting "whipsaw out". My Alibaba CFD trades got massacred that way.
• Use of ATR (Average True Range) to set stop loss - we can take a multiple of the ATR, add or subtract it from the close, and place the stop at this calculated price. Limitation: The time frame chosen is important, the ATR for volatile stocks may vary quite a bit for the different chosen time frames.
• "By nature, a trend trading system will always give back some of the open profits when used with a trailing stop. The only way to prevent this is to set profit targets. However, setting profit targets can limit the amount of gains on the trade. Some trailing stops based on volatility can prevent capturing a large trend if the stops are moved too frequently. (Means trailing too closely.) Other volatility based trailing stops may "give back" too much of the open profits. (Means trailing too far.)" [Reference: https://www.investopedia.com/articles/trading/09/volatility-stops.asp]
• After a breakout, old resistance levels should act as new support and old support levels should act as new resistance. When a stock breaks a support level, old support becomes new resistance. In the majority of trades, the stock will retest the level it has broken after the first couple of days. Be prepared for it.
• For stocks with big potential to move in a certain trending direction (can gap up and pull back quickly), use a limit stop order instead of trailing stop order that might risk getting whipped out on pull back. Sometimes a wide trailing stop may get 'closed' after overnight gapping occurs. 

  

  Alibaba Nov 2018 candlesticks

• Traders' risk in using stop losses...
  "For starters, market makers are keenly aware of any stop-losses you place with your broker and can force a whipsaw in the price, thereby bumping you out of your position, then running the price right back up again. And in the case of a trailing stop, there looms the possibility of setting it too tight during the early stages of the stock garnering its support. In this case, the result will be the same, where the stop will be triggered by a temporary price pullback, leaving traders to fret over perceived lost. This can be a tough psychological pill to swallow." [Reference: https://www.investopedia.com/articles/trading/08/trailing-stop-loss.asp]

My Case Study - Alibaba (BABA)

Alibaba price chart 2019

Alibaba is a stock that I have been trading both on CFD and normal since last year. It is definitely not an easy stock to trade due to its high inter-day and intra-day volatility. For information, it has a high beta of 2.28 (source: https://www.reuters.com/companies/BABA.N/key-metrics). 

Observe this from the chart above - we can spot multiple price gaps and candles with long body and wicks. If you are looking for short-term punts with close trailing stop losses, you will be in for a shock because you could get easily get whipped out in a day. Just look at the wild intra-day volatility (presented by long wicks) and high ATR. Yeah, it's like a cherry tree and we can eat cherries until vomit lol!

The beauty of it, on the other hand, is its price tends to take the lift down (blame it on Trump's tweets). But looking at the bigger picture, you will see that it normally gives a good ride up after that (when sky clears). So if you can catch it at support levels, don't be too quick to set a trailing stop and have the stomach to withstand a bit of a down ride before the bounce (if trending upward). Also take note of the resistance levels, at which we might want to take some profits. It takes patience (tons) to get there.

However, if the market is down-trending yet you have set up a long position, setting a limit stop may be suicidal. Because when the price gaps down beyond the limit stop, your stop order will not get triggered. So it's practically useless!

Example of a gap down to $176

What's more annoying is after the gap down (which may trigger you to panic sell), the price starts moving up. Yes, it's like a bungee jump with pull-back.

That concludes my case review.

Stop loss is really an art to master. There is 'no one method fits all' kind of stop loss technique. It depends on the market conditions, your chosen stock's volatility, the entry price, risk tolerance level etc.

In a fluctuating market that can't seems to make up its mind on a direction, just forget about trading -

because we will not be able to make up our mind for a logical stop loss point.

What are your experiences with stop losses?

Disclaimer: This is not to encourage any trading or investment in Alibaba stock and currently I am not vested in it. Data posted are for illustration purposes only.

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