Traders, Defend Against the Dreaded Death Spiral
It has often been said that there is only two ways to get hurt really bad on a stock trade, getting caught in a "death spiral" by not using DTM: Decisive Trade Management in the way of stop loses and having a stock halted on you. Halts you have zero control over. Death spirals are of your own making if you do not practice the use of stop loses.
Very simply stated Decisive Trade Management is keeping a stock form moving to far against you when the trade goes bad. It is not impossible to have 5 or 6 out of 10 trades lose money and still be profitable for the net of the total 10 trades. What you must do is keep your loses small and manageable and try to maximize you winners. This is done with the proper use of Trading Stops and a strict discipline in using them.
Capital Preservation
It is my firm belief that capital preservation is one of, if not the single most important thing a trader has to concentrate on. It is also my belief that it is always better to error on the side of safety or caution, in general this all comes under DTM: Decisive Trade Management.
Stop loses and the discipline to use them are part of DTM
When you enter a trade, you should have both a possible profit figure or gain that you hope to obtain and a downside loss that "you" are comfortable with if the play turns against you. Only "you" can make that decision as to what these limits are. You are the only one that can determine you risk tolerance and ability to absorb loses on an individual trade. Factors on which these limits are determined include the amount of money you have in your account, your experience and knowledge of the particular stock, news or events affecting the trade and over all market conditions and possibly others. As an example, a trader trading a $250,000 account is more then likely better able to take a $2.00/shr hit on a stock then the trader trading a $25,000 account. Some traders will consider just how well they may have done on a previous trade or number of trades and let the stock run a bit more against them if they have already made a few good trades or if they need to make up for a bad trade or two. This is very risky. I personally don't like to see risks taken in direct relation to previous trades. I would much rather see a plan that is in effect straight across the board. This goes along with my thinking that ever trader should have a trading plan and then you work your plan. (See Trading Plan: Everyone Should Have One) But human nature what it is, I'm sure the balancing trades against one another is probably being done all the time.
As a personal guide, in a market with very tight trading ranges, I'd think twice before letting a sock turn down by 50 cents or so. That is a very tight stop loss for the most part; again this can be flexible depending on your knowledge of the stock and its trading habits coupled with your own tolerance for loss. On an $85 stock, 50 cents is not all that much, but on a $9-10 stock it's a much larger percentage. Markets trading in tight ranges and lacking volatility make it much more difficult to recover loses if the follow through is just not there. If the average profit in a trade is 25-75 cents, then letting one get down on you a buck or more is going to wipe out most if not all of the previous gains on two or three plays. It can take that many trades to get back to even.
On the other hand some stocks can move $2 or $3 in a heart beat and reverse just as quickly for $2 or $3 move into the money for a total of $4-$6 or more. A $.50 stop on these will have you stopped of the trade and out of the money more often then not. I suggest that unless you are familiar with these stocks that have a history of wild swings that you avoid them until you get familiar with them.
The Trading Stop Itself
It is the opinion of many experienced traders and one that I share, that the stop order should not actually be placed. Instead you determine what price it should be and be ready to place the order if and when the trade turns against you and nears your stop price. This is referred to as "mental stops". You can even go as far as having the order form all filled out and ready to execute as the price approaches your stop price. A lot of the newer trading platforms will allow you to actually place the order in their system but it is not sent to the market for execution until the price is reached.
When you actually place the order, you lose control of you trade. Many systems do not allow you to have two orders on the same position at the same time. If you want to sell the stock you first have to cancel the stop and get confirmation back before you can place another order.
On a stock that is moving rapidly against you some traders prefer to use a market order for the quick exit. I do not like the use of market orders any under circumstances. There are too many pitfalls involved with the use of market orders. Instead I suggest you use a limit price that is significantly lower then the bid that assures you get a fill.
However you chose to exercise the use of stop loss orders is up to you but it has to be done. DTM with the use of stop orders is the only way to defend against the dreaded death spiral.
See more Trading Tips at http://www.TraderAide.com
There are many excellent books on learning to day trade. My favorites are found at http://www.TraderAide.com/books
About the Author: Floyd Snyder has been trading and investing in the stock market for three decades. He was on the forefront of the day trading craze that swept the nation back in late1990's both as a trader and as the moderator of one of the Internet's largest real time trading rooms. He is the owner of http://www.TraderAide.com and Strictly Business Magazine at http://www.sbmag.org
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