Placing Your Stops Correctly

Feb 7th, 2013 | By | Category: Steven Spencer (Steve's) Blogs, Trader Development
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If you become skilled at stop placements your win rate increases. It’s a skill that we teach traders on our desk but it is something that takes live trading experience to ingrain in a trader’s brain. Newb traders are all over the place in this area. You have some who will risk a few cents, which is awful in an HFT market, and there are those on the other side of the spectrum who think “if I just gave it some more room it would have worked”.

Two things you have to realize when placing a stop: 1) they shouldn’t be randomly placed at a predetermined distance from your entry and 2) once you figure out the correct stop for a given setup you have to calculate whether the profit target is sufficient to justify the amount of risk the trade requires—risk/reward ratio.

Let’s take a look at two trade ideas from today. The first was in MHP. This was a third day play. It continued to show weakness on the Open so I wanted to initiate a quarter short position. After immediately filling its higher gap in the first few minutes it quickly spiked higher before resuming its downward price action. I used the top of the spike at 45.23 as a reference to initiate my position. I placed an offer at 45.10 while it was trading around 44.90. As soon as the 45 offer lifted it spiked higher and my offer was taken for the initial short. I placed my stop at 45.26.

The risk on this trade was probably around 20 cents if you factor in about 4 cents of potential slippage on my stop. I thought the potential upside was at least to 43.75 where it had bottomed the prior day so reward of $1.35 or more, so a risk/reward of better than 1:5, which is what we look for in our setups.

The next trade idea was in BIDU which was a second day play. BIDU had gapped lower on earnings the prior day and on the Open started to trade lower and I initiated a short position below a 96.70 seller. Eventually I was stopped out when it spike above 96.75. This failure to test the prior day’s support area at 95.50 caught my attention. I also saw a lot of buying on the way down the prior day starting at 98.50. Those factors in addition to the overall strength in the market recently got me to focus on a possible long setup.

So when BIDU started to hold above 97 I shared my thoughts on StockTwits that it looked like it was bottoming. I had a good reference point at 96.70 where I had initiated my short earlier and I had an upside target to the prior day’s Open of 99. There could be some trouble at 97.75 as it failed at that level two days in a row so it wasn’t an A setup, but there were enough checks to start nibbling the longer it held above 97. That is what it did so I shared the trade idea on SMB RT with the correct stop.

It turned out that this setup never came close to testing the 96.70 support and trended all the way to 99. The risk/reward for the trade was better than 1:5 with 35 cents of risk for upside of $2, but that 97.75 resistance made the profit target a lower probability so it wasn’t a trade to load up.

Steven Spencer is the co-founder of SMB Capital and SMB University and has traded professionally for 16 years. His email is sspencer@smbcap.com.

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