Introduction to Trade Management
The stock traders best kept secret
A stock trader's trade management strategy forms the basis for successful trading. Without it most stock traders simply end up losing money. Many beginner stock traders are under the impression that any trade they enter will simply yield a profit as long as they incorporate technical analysis techniques. The reality is that it is more difficult to make money from stock trading than it is with long-term stock investing strategies.
Trade management is even more important for a stock trader than technical analysis is. While technical analysis provides a sound rational basis for deciding on whether to enter a proposed trade, it does not guarantee that the stock trader will be trading at a profit.
The trade management concepts are discussed in the following sections.
Stock Market Knowledge
This is extremely important for the stock trader and is probably the single biggest reason why beginner stock traders fail. At the heart of stock trading is technical analysis and any stock trader who does not have a sound knowledge base in technical analysis has no rational basis for their trade entries.
Even stock investors with a sound knowledge of fundamental analysis will have a difficult time with short-term trading since the short-term stock price movements do not directly follow the long-term fundamental valuation of the stock. While it is true that the stock's price will generally alternate between being overvalued and being undervalued at some stage, this typically takes years whereas short-term trading typically lasts several weeks up to several months. Therefore stock investors who are seeking some short-term trading will do well by obtaining a sound knowledge base of technical analysis.
In addition to technical analysis stock traders benefit immensely from having a good working knowledge of market dynamics. This includes the role of market makers, the Bid-Ask spread, long-term market cycles such as bull and bear markets, short-term bullish and bearish cycles and industry groups.
One of the pitfalls that stock traders (especially beginners) find themselves in is that of taking on too many trades consecutively. This exposes the stock trader to a significant amount of market risk and when the market turns (which is usually sooner than later) these stock traders will endure a large portion of their trades yielding a loss.
The problem this creates for the stock trader is that emotions take over and the stock trader typically becomes obsessed with trying to recoup these losses which leads to what is known as revenge trading. The stock trader now becomes aggressive which leads to a lot of poor trades being entered which only further increases their losses. The end result is that excessive trading generally leads to failure.
Keeping Trade Records
Successful stock traders keep detailed records of all of their trades entered whether they yielded a profit or a loss. The purpose of keeping these records is so that the stock trader can analyze their trades and determine the profitability of their trading strategies. This analysis will also highlight market conditions that are not favorable to the stock traders chosen strategies.
Should the stock trader's post-trade analysis show that they are only marginally profitable or worse that they are running at a loss, then the stock trader can temporally postpone taking on any new positions while they determine the source of the problem.
Trading in the direction of the market is generally easier and more profitable than trading against the market. In addition it is easier and more profitable to trade a trending stock in the direction of stock's trend. Not trading with the market or with a trending stock typically leads to poor results.
A stop-loss is simply a predetermined price level where a trade is exited when the stock's price moves against the chosen trade direction.
Stock investors often wonder why a stock should be sold if it moves downwards rather than holding the stock waiting for the price to recover.
A small profit can be offset by a small loss,
however a big loss requires a big profit
The consideration here is that stock investing is a long-term process which yields significant gains (which can be many hundreds of percent). These large gains significantly outweigh the losses from a losing investment. However with short-term trading the gains are only small (somewhere around 10% or less) so holding a losing trade can largely outweigh the relatively small gains from a winning trade.
The general rule is that large gains can withstand large losses and small gains can only withstand small losses. The only way to keep losses small is to exit the trade before they become large losses.
While holding onto a losing trade waiting for it to breakeven tends to work in a bull market, it is absolutely disastrous in a bear market and leads to a massive loss.
The Risk-Reward is a ratio that stock traders use to determine whether a proposed trade has sufficient profit to justify the risk taken. Beginner Stock traders are renowned for not evaluating the risk and reward of a proposed trade which results in them taken positions that have very little profit potential relative to the losses their incur when a trade goes against them. They generally assume that all of their trades will yield a profit, however the reality is that the stock trader can incur upwards of 50% of losing trades.
To be successful with stock trading, more money needs to be made with the profitable positions than what is lost with the losing trades. By conducting an analysis of the Risk-Reward ratio of a proposed trade, the stock trader can select the more favorable trades to enter and bypass the less profitable trades.
An important aspect of trade management is Trading psychology which is something that all successful stock traders are fully converse with and essentially deals with the emotional attitudes of stock traders.
When a stock trader is making money their emotional state of mind is positive and they tend to make logical and rational decisions. However when stock traders lose money (especially beginners), they become anxious and determined to recoup their losses which puts pressure on themselves. As a general rule when most people are under pressure their ability to make logical and rational decisions is impaired. This is no different for the stock trader who now starts to make poorer trade decisions which has the undesirable result of yielding poor results thus increasing their already poor trading results.
Understanding human psychology helps the stock trader realize when they are under pressure and that they still need to think and analyze each proposed trade logically and rationally. Simply being aware that ones ability to rationalize diminishes with stress helps the stock trader by controlling their own emotions and not letting it override their logical reasoning.
Stock Order Types
With the internet, brokers can provide traders with a wide variety of order types
Stock brokers generally offer their clients a variety of different order types over the internet. These orders allow the stock trader to manage the entry and exit from their positions.
The following is a list of the common order types available from most stock brokers. While there are numerous other specialty order types, only the order types commonly used by stock traders are listed. The exact names of the order type may vary between stock brokers and some stock brokers may not offer all order types listed.
A Limit order is a basic order to buy or sell stock at specified price. The idea of the Limit order is to limit the maximum amount paid to buy stock and to limit minimum amount received for selling stock.
With a buy Limit order, the stock trader specifies a maximum price known as the limit price. A buy Limit order can only be filled at the limit price or less. With a sell Limit order, the stock trader specifies a minimum price which is also referred to as the limit price. A sell Limit order can only be filled at the limit price or higher. Limit orders are usually filled at the limit price, but there are exceptions.
Beginner stock traders are usually confused about what the market price actually refers to and assume it means the last price paid. While this is true when the financial press reports the closing price (which is simply the last traded price before the markets close), when referring to stock orders the term market price actually means "the best Bid price and the best Ask price" and not the last traded price. The best Ask price is the lowest price currently available to buy stock with a market order and the best Bid price is the highest price currently available to sell stock with a market order.
The stock trader can specify a limit price which is above or below the current market price.
If the stock trader specifies a limit price for a buy order which is below the current Ask, then the order is queued and will only be filled when the best Ask price drops down to their limit price. Similarly for a Limit sell order, if the limit price is above the best Bid, then the order will be filled when the Bid rises up to the limit price.
For a buy order, if the specified limit price is above the best Ask and there are sufficient shares at that Ask to fill the order, then the order is immediately filled and the stock trader pays the Ask price (which means the price paid is less than their limit price). Similarly for a sell order, if the limit price is below the best Bid, the order is filled immediately and the stock trader receives the Bid price.
When a stock trader specifies a limit price above the best Ask for a buy order, they may be filled at Ask price levels which are above the best Ask price if their share quantity exceeds the number of shares available at the best Ask price. If the buy limit price is not high enough, then the stock trader may not have their entire order filled (which is referred to as a partial fill).
The market prices for each stock are displayed on a quote screen known as a Level 2 which shows all the current prices along with the corresponding share quantities that are available to be bought and sold. The best bid is the highest bid on the Level 2 and the best Ask is the lowest ask on the Level 2. The best Bid and best Ask are shown on the first line on the Level 2 quote.
The Level 2 quote example in Figure 1. illustrates how a Limit buy order works when there are insufficient shares available to fill the entire order. The example Limit buy order is for 500 shares with a limit price of $20.04.
Table 1. Market prices – Level 2 quote
From Figure 1. above, the stock trader's order to buy 500 shares at $20.04 only filled 400 shares with 100 shares still waiting to be filled. The buy order was partially filled and the stock trader received 100 shares at $20.02, 100 shares at $20.03 and 200 shares at $20.04. Should the stock trader wish to receive the remaining 100 shares, then the limit price will need to be raised to $20.05 or the stock trader will need to wait for another market participant to place a market order and take the stock traders remaining 100 shares at $20.04.
The advantage of using a limit price is that the stock trader knows in advance the maximum price they will be paying for stock or the minimum price received for selling their stock. The disadvantage is that if the stock does not trade down to their limit price for a buy order, then the buy order is not filled and the stock trader does not receive any shares from that order. Similarly, if the stock does not trade up to the limit price for a sell order, then the sell order is not filled.
The Market order is similar to the Limit order except that the stock trader does not specify a limit price. Beginner stock traders generally are under the impression that a Market order means that they will receive the last traded price for their Market order. Some even think they will receive yesterday's closing price. The reference to 'market' means the "best Bid and best Ask" which is also known as the market price (which is not the last traded price).
A Market buy order will simply take the best Ask price. If there are insufficient shares available at the best Ask price to fill the order, then these shares are taken and the next available Ask price level is used to fulfill the remaining shares. This is illustrated using the example from Table 1. for the Limit buy order. If the stock trader places a Market buy order for 500 shares, then the entire order is filled and the stock trader receives 100 shares at $20.02, 100 shares at $20.03 and 200 shares at $20.04 and 100 shares at $20.05.
The Market sell order takes the best Bid price and if there are insufficient shares available then the next Bid price level is used and so on until the entire order is filled.
The advantage of using a Market order is that the stock trader will always get their order completely filled. The disadvantage is that the stock trader has no control over the prices paid for a buy order or the prices received for a sell order. To a large extent this can be minimized if the stock trader has access to the market quotes when placing their order. The Bid-Ask prices and their corresponding available shares are displayed on the market quote. So even if a Market order is placed the stock trader knows basically what their fill prices will be, which works fine when under normal market conditions. However the stock trader needs to be aware that in fast moving markets the quotes can change before their order arrives at the market. Also the open can be extremely volatile with the Bid-Ask prices changing quickly.
The Stop order is commonly used by stock traders as a stop-loss order. With this order type, a trigger price is specified and the order executes as a market order when the trigger price is reached.
Stock traders frequently use this order type as a sell order to exit their position if it trades below their stop-loss level. To use this order type as a stop-loss, the trigger price must be specified which must be below the current market price. Some stock brokers allow the trigger type to be set which by default is the last traded price, but some stock brokers allow this to be set to either the Bid price or the Ask price. Generally it is better to use the last traded price which is the most common trigger method used by stock traders. The order will be placed as a Market sell order when the last traded price reaches the trigger price.
Stop loss orders in various forms are
commonly used orders with traders
The Stop order works similarly with a short sale. The trigger price must be above the current market price and the order will be executed as a Market buy order when the last traded price reaches the trigger price.
Some stock traders will use the Stop order as an entry order. The Stop order is a convenient order type to use when the stock trader only wants to buy a stock if it trades above a certain level. For example, a swing trader who only wants to buy the stock if it trades above yesterday's high can set the trigger price as yesterday's high plus say five cents. A Stop buy order will execute as a Market buy order if the last traded price reaches the trigger price. If the last traded price does not reach the trigger price then the order is not executed.
The entry Stop order can also be used for short sale entries. The trigger price must be below the last traded price and the order will execute as a Market sell order only if the last traded price reaches the trigger price.
This order type is basically a variable Limit order that is constantly and automatically amending the limit price as it tracks the market price. The purpose of this order type is to dynamically follow the market price.
While any stock trader can use this order type, it is most commonly used by traders who trade the Bid-Ask spread. Since the best Bid and the best Ask are constantly changing, stock traders who trade this spread need to constantly amend their limit orders. Needless to say it is a massive task to manually amend limit prices to keep pace with the ever changing market prices. To make life easier for the Bid-Ask spread trader, some stock brokers have an automated order type that does these amendments automatically.
For a buy limit order, the stock trader places a Relative buy order and specifies an offset amount which is how far above or below the current best Bid that their limit order will be placed. For example, if the trader specifies a -0.01 offset, this means that when ever the best Bid changes, a Limit buy order is placed that is $0.01 (one cent) less than the current best Bid. When the best Bid changes again, the previous Limit buy order is canceled and a new Limit buy order is placed one cent below the new current best Bid. This amending of the limit order continues for as long as the order is active.
If a +0.01 offset is specified for a Relative buy order, the Limit buy order is placed one cent above the current best Bid. With a zero offset specified, the Limit buy order is place at the same price level as the current best Bid which means that the limit price is constantly amended to match the current best Bid.
A Relative sell order works in the same manner as the Relative buy order. A +0.01 offset makes the order more aggressive and places a Limit sell order one cent below the current best Ask. A -0.01 offset is more conservative and places a Limit sell order one cent above the current best Ask.
While this order type is ideally suited to Bid-Ask spread traders, it is usually not worth using for stock traders who use trading strategies that require a fill at a certain price or require an immediate fill. The purpose of the Relative order is to follow the market price rather than provide a fill at a designated price.
Stock Order Attributes
Increase the versatility of your order
Stock order attributes are additional conditions that can be added to the standard stock order types. These attributes increase the flexibility of the order and the most common attributes involve a time and/or date condition which restricts the orders execution to these times and dates. Another popular attribute is the ability to group several different orders together.
This order attribute is the most basic one which simply leaves the order active until it is completely filled. Some stock brokers have a maximum limit as to how long an order will remain active before the stock broker cancels an unfilled order.
This attribute is usually attached to a Limit order by stock traders who use a profit target. So for a long side trade, the stock trader places a Limit sell order at their profit target price and chooses Good-till-Canceled as the attribute. This saves the stock trader from continually having to re-enter their Limit sell order. However the stock trader still needs to be aware of the time limit (if any) that the order will remain active for (which might be somewhere around one month).
With this order attribute the stock trader can specify when the order should be canceled. The most common use of this attribute is to specify a Day-only condition which means an unfilled order is canceled after the market closes. For example, a swing trader places a Stop buy order to buy stock if it trades above yesterday's high but if the order is not filled then the stock trader does not want the order to remain active beyond the current day. Specifying a Day-only attribute saves the stock trader from having to remember to manually cancel an unfilled Stop buy order after the market closes.
Time attributes are particular useful for traders
who do not monitor the markets during the day
The stock trader can specify the date and/or time that the order will be canceled. If only the date is specified then the order will be canceled after the market closes on that date. If only the time is specified then the order will be canceled when that time is reached on the day that the order is placed.
This is a time delay attribute which only allows the order to become active on the time and date specified.
The common use of this order attribute is when stock traders such as position traders use a trailing stop-loss based on closing prices. When their stock triggers the stop-loss, since the market is closed the stock trader must place an exit order to be executed the next trading day. With this order attribute the stock trader can place their exit order such as a Market sell order with a date attribute (which is the next trading day) and a time attribute. This allows the stock trader to place their order while the market is closed.
A lot of stock traders do not like to have their market orders executed at the open due to the wide Bid-Ask spreads and high volatility, the stock trader can specify a time after the open such as 10:30 AM ET and the order will only become active at that time (an hour after the open).
If no date is specified then the order will become active after the specified time on the day the order is placed. If only the date is specified then the order will become active at the open on the date specified.
This order attribute will become active when the market opens on the current trading day. This order attribute is simply the Good-after-Date/Time attribute with the date set to the current trading day and the time set to 9:30 AM ET.
While the stock trader could simply enter the date and time in the Good-after-Date/Time attribute, the Market-on-Open attribute simplifies this by not needing to enter the start date and time. This order attribute allows a stock trader to enter their order into their stock brokers system the night before and the order will be executed when the market opens. Note that this is not the same as entering a Market order the night before since most broker systems will reject a Market order since the market is closed. Remember that a Market order is an order for immediate execution.
This order attribute will become active when the market closes on the current trading day. This order attribute is simply the Good-after-Date/Time attribute with the date set to the current trading day and the time set to 4:00 PM ET.
This order attribute is simply the Market-at-Open attribute but executes at the markets close. Some position traders prefer to use the closing price of the day after their stop-loss is triggered. This comes about since they are using closing prices for their charting indicators and the exit price they receive will also be a closing price.
Some stock brokers allow several different orders to be linked together. This is convenient for stock traders as they can place an initial stop-loss order together with a price target Limit sell order. With these two orders grouped, if the stock trades up to the price target then the Limit sell order is filled and the initial stop-loss order is canceled. If instead the stock trades down and triggers the Stop price of the Stop order, then the Market sell order is executed and the Limit sell order is canceled.
This order attribute can be used with any order types and more than two orders can generally be linked together. The orders can even be from different stocks. For example a day trader is tracking three stocks but only wants to buy one stock and will buy which ever stock pulls back to their support level first.
The day trader can place a Limit buy order at the respective support price levels for each stock and group these three stocks together with the One-Cancels-All attribute. Which ever stock pulls back to their support level first is the Limit buy order that is executed and the other two Limit buy orders are immediately canceled.
Various techniques to manage risk
The basic principle of the stop-loss is to limit the amount that a stock's price can move against the stock trader's chosen trade direction and is an important component of trade risk management. The famous speculative stock trader - Jesse Livermore always exited any position which traded against his chosen direction. Jesse Livermore is largely credited with developing the idea of exiting a losing trade - which is known nowadays as a stop-loss.
The stop-loss serves two purposes. The first is the initial stop-loss that is initiated when the stock trader places their entry order. This stop-loss is intended to exit the stock trader's position should the stock trade against their position by limiting the amount lost. The second is a trailing stop-loss. When the stock goes into profit, the initial stop-loss level is adjusted so that it is closer to the current price. The purpose of the trailing stop-loss is to capture as much of the move as possible before the trend reverses direction.
For most stock traders their trade direction is on the Long side so the initial stop-loss is placed below their entry price level. Should the stock's price trade down to this stop-loss price level, then the position is exited. Should the stock's price increase above the entry price by a certain amount, then the stop-loss level is raised above the entry price and becomes a trailing stop-loss.
The following discussion will be based on long side trades. Short sell trades are merely the inverse of the long side trades.
The stop-loss principle is illustrated in Chart 1. showing the initial and trailing stop-loss levels for an uptrending stock making higher Relative Highs and Lows. The trailing stop-loss shown in Chart 1. is raised to the next higher Relative Low whenever the stock trades above the previous Relative High.
Chart 1. Initial and trailing stop-loss using Pullback Lows
The stop-loss levels in Chart 1. above are applied to a bar chart, even though a line chart or candlestick chart can used. Using the pullback stop method in Chart 1. the initial stop is raised to stop 1 when the stock trades up to Label 1. Once the stock trades up to Label 2. the stop is then raised to Stop 2. This process continues until the stock is stopped out.
The stop-loss can be used on daily, weekly, monthly and intraday charts.
Chart 2. below shows the pullback stop method applied to a weekly chart.
Chart 2. Weekly Chart with Pullback Low stop
The exit signal can be given when the stock trades below the stop level or when the stock closes below the stop level.
Note that after the stop has been triggered the stock may trade back up. Generally it is best to exit at a profit rather than hold the position after triggering the stop since the stock can always sell-off at any time.
Determining the Initial Stop-Loss level
There are several methods that can be used to determine the price level for the initial stop-loss.
The simplest method is to use a fixed percentage based on the historical volatility of the stock. Some stocks are more volatile meaning that the bars fluctuate more and this requires the stop-loss level to be placed lower than a stock that is less volatile.
While the percentage method has its merits (particularly for trade entries taken from a chart indicator such as the MACD), most stock traders generally prefer to base the initial stop-loss level on a chart pattern. This is especially the case if the trade itself is based on a chart pattern, rather than a chart indicator. Chart 1. above showed an entry based on break through a trend line and the initial stop-loss was set just below the Low.
An alternative method favored by some stock traders that exclusively use chart indicators is not to set a fixed initial stop-loss, but rather allow the chart indicator signal an exit. Thus the initial stop-loss level is not known in advance as it is depended on the subsequent price movement of the stock. There is no right or wrong method in setting an initial stop-loss and to a large extent it is dependant on the stock trader's trading style.
An example of entering and managing a position using the Moving Average cross over system is shown below in Chart 3.
Chart 3. Moving Average Cross Over Stop
Chart 3. above uses two exponential moving averages, the Red line is a 10-day and the Green line is a 30-day. An entry is taken when the 10-day crosses up over the 30-ady. There's no trailing stop used as an exit is given when the 10-day drops below the 30-day.
The Moving Average cross over system in Chart 3. can also be used with weekly charts or even monthly charts.
Determining the Trailing Stop-Loss level
As the trade goes further into profit, the distance between the current stock price and the initial stop-loss level starts to become significant. Should the stock's price increase peak and reverse, then this open profit would disappear and the stock trader would end up exiting at their initial stop-loss at a loss. The idea of the trailing stop-loss is to raise the stop-loss level so as to lock in any open profits should the stock's price advance reverse.
Similar to the initial stop-loss level, there are several methods for determining when and where to raise the initial stop-loss level.
Again the simplest method is to use a fixed percentage based on the historical volatility of the stock. For an uptrending stock, each time the stock makes a new high price above the entry price level, the trailing stop-loss level is raised so that it is a fixed percentage below this new high price. The fixed percentage to use is the value that was used to place the initial stop-loss. Therefore if a 5% value was used to set the initial stop loss level, then each time the stock makes a new higher price, the trailing stop is raised so it is 5% below the new high.
Most stock traders tend to prefer to use chart patterns to determine the trailing stop-loss level. Generally, as the stock continues its upward move, the stock trader will locate logical Relative Lows or lows/trend-lines of other chart patterns such as Triangles. Chart 1. above shows the trailing stop-loss level being raised to just below the Relative Low of each successively higher Pullback in an uptrending stock.
Another popular trailing stop-loss method is to use a mathematically calculated level with the most common one used being the Parabolic SAR (which stands for Stop and Reverse) which is actually a trend following indicator that plots a dot on the chart for each day's trailing stop-loss level.
Chart 4. SARs Indicator Stop
The SARs indicator parameters in Chart 4, above were set to (0.03,0.03) which gives the stock plenty of room to move. Using tighter parameters like setting the second value to 0.3 instead of 0.03 results in a tight stop which sees the stock being stopped out much earlier.
Some short-term traders such as swing traders are only seeking the Rally up to the first Relative High. While these traders typically use the Relative Low for their initial stop-loss level, they will frequently use a trailing stop-loss that is placed below the low of the preceding day (so long as it is the highest low in the rally). These swing traders are expecting the rally to make higher lows on each consecutive day of the rally and if the stock trades below the low of the previous day (or the highest low), the position is then exited.
The Prior day's low stop method is shown below in Chart 5.
Chart 5. Prior Day's Low Stop
Swing traders often exit using stop loss orders which automatically sells their position once the stock traders below the stop level. Some traders prefer to allow the stock more leeway and use a close below the stop as a signal to exit their position and the stock is usually sold the following trading day. Chart 5. above compares the trade below vs. close below methods.
A variation to the prior days low method is to use the second day's low. This gives the stock more room to move before being stopped out. With this method, the stock trader locates the highest low in the rally and then locates the second highest low. If this second low day is higher than the current trailing stop-loss level, then the stop-loss level is raised. If it's less than the stop level then the stop is not raised (since stops are only raised and not lowered for long side trades).
The Second day's low stop method is shown below in Chart 6.
Chart 6. Second Day's Low Stop
From the above chart, the stop is triggered when it trades below the low of the bar Labeled 2. for the first stop shown. For the second stop shown, an exit is signaled when the stock closes below the low of Label 2.
Yet another stop variation is to use the third day's low. This gives the stock even more room to move before being stopped out. With this method, the stock trader locates the third highest low. If this third low day is higher than the current trailing stop-loss level, then the stop-loss level is raised. If it's less than the stop level then the stop is not raised (since stops are only raised and not lowered for long side trades).
As with all other stop methods the Third day's low stop can also used with weekly charts.
Chart 7. below illustrates the Third day's low applied to a weekly chart.
Chart 7. Weekly Chart Third Day's Low Stop
When using weekly charts, the bar is not completed until the trading week is completed (usually 4:00 PM Fridays). Referring to Chart 7. above, the stop level is the low of the bar Labeled 3. An exit can be taken during the week with a stop-loss market order when the stock trades below the stop or an exit signal can be given when the stock closes the week below the stop level with the stop then sold the following trading day.
Price Target instead of a Trailing Stop-Loss
A trailing stop-loss is practical to use when the expected move is large relative to the initial stop-loss. However, there are trading styles that use a predetermined price level which the stock is expected to reach and the position is exited at that price level. This is a common practice with trading to the price target of chart patterns. The use of a trailing stop-loss will frequently exit the position prematurely, meaning that the stock hits the trailing stop-loss first even though the stock subsequently reached its price target level.
Some stock traders who use price targets do not to use trailing stops when the price target level is not significantly greater than the initial stop-loss level. Other stock traders do not use a trailing stop-loss at all, instead they simply have two fixed exit prices (the initial stop-loss level and the price target) and they will hold their position until one of these price levels is reached.
Traders may prefer not to use a trailing stop when
the profit target is close to the initial stop
Swing traders will often utilize a trailing stop-loss which tracks the prior day's low in conjunction with a price target level. Thus they will exit some or all of their position if it triggers their trailing stop-loss and if the trailing stop-loss is not hit then their position is exited at the target price level.
The use of price targets is a personal choice which some stock traders prefer to use, while other stock traders would rather hold onto their position with the expectation of a larger move.
To summarize, trailing stops are a good idea for moves that are large relative to the initial stop-loss level, but tend to prematurely exit a position when the expected move is relatively small.
There are two different approaches to exiting a position which has triggered a stop-loss level.
The first approach is to automatically exit when the stock's price drops to the stop-loss level during market hours. This is known as an intraday exit and requires the stock trader to place a stop-loss order with their stock broker (which is usually done after their position is filled). When the trailing stop-loss level is increased, the stop-loss order needs to be amended with the new price level. Stop-loss levels are only ever increased and not decreased.
The second approach is to only accept a trigger when the stock closed below the stop-loss level. This means that the stock can trade below the stop-loss level during the day, but an exit is only given if the stock closed below the stop-loss level. Should the stock close below the stop-loss level, then the stock is generally exited the next day during the morning. Some traders will place a market order to exit at the open. However this can produce unfavorable exit prices and stock traders who use closing prices may prefer to place their exit orders with a time delay so that they are only executed after the market opens (the time delay is usually about an hour after the market opens). Some stock traders will exit at the market close on the day after their stop-loss is triggered.
The choice as whether to use intraday triggers or closing price triggers is a personal one. The advantage of using closing prices is that there are less false triggers (where the stock hits the stop but then continues with its uptrend). The disadvantage with closing prices is that should the stock close below the stop-loss level, then the distance it has fallen below the stop-loss level can be quite substantial and thus will result in a greater loss than with the intraday trigger.
Gives the trader an idea of how far the stock might rally
The profit target is a useful trading tool which stock traders frequently use. They use the profit target to exit a trade at a predetermined price level. The profit target is particularly useful for short-term traders such as day traders, swing traders and position traders for exiting a trade that has an open profit. It is common for traders to place a limit sell order at the profit target price level. For a short sale trade a limit buy order is typically place at the profit target.
Profit targets can be determined from a chart pattern or from the stocks historical volatility. A profit target is basically the inverse of the stop-loss where stock traders exit their trades at a predetermined price level to limit the loss on a trade.
Determining the risk-reward ratio is simplified when using a profit target as the reward is known in advance as well as the risk. Without a profit target the stock trader needs to make a realistic assessment of the potential price movement before being stopped out with a trailing stop.
Volatility Based Price Targets
The simplest method of determining a profit target is to base it on the historical volatility of the stock's price movement. The easiest and quickest method to determine the volatility of a stock is to examine the stock's chart and note the highest and lowest price over a fixed time period.
The time period can be say over the last 20 days. This gives an idea of the price range that the stock can trade within. Further examining the 20 day ranges over the prior months will give the stock trader a good feel for the price movement characteristics for the stock.
The number of days selected for the time period should be based upon the intended time frame for the trade. A 20 day time period will be too short if the trader is looking for a longer term trade lasting say six months to a year. In this case a six month time period would be more appropriate.
Generally the closing prices are used for traders who place their orders when the markets are closed. Live traders such as day traders will typically use the highest High and the lowest Low in the period rather than closing prices and they will typically use intraday bar charts displaying five minute bars for the time period. This is a common approach used by scalpers to determine their profit targets.
The stocks volatility is determined over a fixed time period and the trader needs to decide what percentage of that volatility to use as a profit target. Generally using 50% to 100% of the volatility range is appropriate. The stop-loss can also be based on the volatility range.
What percentage to use for the stop-loss is based on the risk-reward ratio that the trader is comfortable with but the ratio needs to be realistic. As a general rule, the tighter the stop then the more frequently the trader will be stopped out. A risk-reward ratio of 2 or 3 is generally a good figure to use.
Stock traders generally do not use a trailing stop when the profit target and stop-loss are based on historical volatility, but this is a personal preference.
If the stock trader does not use a trailing, then the trade is exited when the stock price reaches either the profit target or the stop-loss.
Example: A stock has the highest close of $50 and the lowest close of $45 over the last 20 days which gives it a $5 range that is typical for this stock. The current stock price is $50 and has just broken out of an ascending triangle. The proposed risk-reward ratio is 2.
20 day high-low range = $50 - $45 = $5
Reward = 100% x $5 = $5
Risk = $5 / 2 = $2.50
Profit target at 100% of range = $50 + $5 = $55
Stop-loss at 50% of range = $50 - $2.50 = $47.50
The trade is exited at either a $5 profit or a $2.50 loss.
Chart Pattern Based Price Targets
Stock traders who trade with chart patterns tend to prefer using chart patterns to determine their profit target levels and also use the chart patterns to determine their stop-loss levels.
Some of the standard chart patterns such as a Double Bottom have a set method of determining the profit target level. The trader does however need to be aware of any significant support or resistance level which may hinder the stock price from reaching its price target.
Similarly to using the stocks historical volatility, when traders use a price target they tend not to use a trailing stop. There are advantages and disadvantages in not raising the stop as the stock price advances towards its profit target. One disadvantage is that raising the stop will frequently cause the stock to be stopped out prematurely and thus alters the risk-reward ratio. The advantage is that if the stock price does not quite reach its profit target before reversing and sells down to its initial stop, then at least the trader has locked in some profit. The choice in using a trailing stop is a personal preference.
The price target for an Ascending Triangle is shown below in Chart 1.
Chart 1. Ascending Triangle price target
The height of the Ascending Triangle from chart 1. above is added to the upper boundary to give the price target.
The price target for a Symmetrical Triangle is shown below in Chart 2.
Chart 2. Symmetrical Triangle price target
The height of the Symmetrical Triangle from chart 2. above is added to the breakout level though the upper down sloping boundary.
Another example of determining a price target is shown below in Chart 3. for a Flag chart pattern.
Chart 3. Flag Pattern price target
The height of the Flag Pole from chart 3. above is added to the breakout level though the upper boundary. Some traders are more conservative and add the flag pole height to the lowest low of the flag (lower boundary).
An example of determining the price target for a stock with a pullback is shown below in Chart 4..
Chart 4. Pullback Rally price target
The profit target in Chart 4. above is determined by adding the height of the previous rally (Labels A to B) to the bottom of the pullback low (Label C). Short-term stock traders frequently use these price targets and exit once the target is reached.
Price targets can also be used for weekly charts and even monthly charts.
Shown below in Chart 5. is an example of determining the price target from a weekly chart for a stock that pulled back.
Chart 5. Weekly Pullback Rally price target
The price target for the weekly chart above is determined in the same manner as with a daily chart. The height of the previous rally (Labels A to B) is added to the bottom of the pullback low (Label C). Using price targets from weekly charts allows long-term traders to use the same target principles as that used by the short-term traders.
Determine whether the trade is worth the risk
The risk-reward ratio is a simple trade selection tool that stock traders use to determine whether a proposed trade is worth taking. Not all trades lead to a profit and the stock trader will end up with a fair amount of losing trades (which can be up to 50% of all trades taken).
All trading involves risk and to trade profitably the stock trader needs to make more money on the profitable trades than what they lose on the trades that trigger their stop-loss levels at a loss.
The Reward component of the ratio is based on the realistic amount of profit that could be made from the trade. For trades that use a profit target, the reward is simply the profit target. However for trades that follow a trend, the reward needs to be realistically determined based on the typically trend lengths for that particular stock. Sometimes this is not possible so the trend lengths can be based on similar stocks. Any significant resistance levels need to be taken into account as they may hinder the advance of an uptrend (similarly a support level can hinder the downtrend for a short position).
The Risk component of the ratio is simply the initial stop-loss level selected for the proposed trade. The risk-reward ratio is calculated by dividing the Risk by the Reward.
Example: A proposed trade with a $30 buy price has an initial stop-loss is placed at $29 and a price target of $33.
The Risk is $1 ($30 buy price less the initial stop-loss of $29)
The Reward is $3 ($33 price target less the $30 buy price).
The Risk-Reward ratio is 1 to 3 which is usually referred to as Risk-Reward ratio = 3.
A stock that has a Risk-Reward ratio = 3 does not mean that the stock will necessarily make three times the initial stop-loss before being stopped out, but that it has the potential to make three times the risk. When a trailing stop is used, a lot of profitable trades tend to be stopped out with rewards that are less than the reward that was originally anticipated.
Potential trades that only have a Risk-Reward ratio of around 1.5 or less are generally not worth taking as brokerage costs also need to be taken into account.
When the risk-reward ratio is low, brokerage costs
can make the trade unprofitable
Stock traders that use a trailing stop-loss generally require higher risk-reward ratios than stock traders who use price targets without a trailing stop-loss. This is because the trailing stop-loss has a tendency to prematurely exit profitable trades and thus requires a higher ratio to compensate for this loss of profit. As a general rule, stock traders using a trailing stop-loss will not consider any trades with Risk-Reward ratio less than 3 and some stock traders will use minimums much higher than this. Stock traders who use price targets with a trailing stop-loss tend to use minimum Risk-Reward ratios of around 2.
Another consideration with the Risk-Reward ratio is the success rate which is simply the ratio of profitable trades to losing trades. Price target trades tend to have higher success rates than trend following trades, primarily due to price target trades having a lower price move expectation which is easier to reach. This is one of the reasons a lower Risk-Reward ratio can be used. With trend following trades a high proportion of trades are stopped out before the expected price level is reached which generally produces a lower success rate.
Many beginner stock traders fall into the trap of needing to trade all of the time. The market has a strong tendency of cycling through stages where at times there are a lot of good Risk-Reward trades available and at other times the only trades available are those with low Risk-Reward ratios. Taking positions in these low Risk-Reward trades just for the sake of making a trade does nothing but lose money and has the negative effect of lowering the beginner trader's confidence due to the low profitability and high loss rate. This is an aspect of trading where there are times when there is nothing worth trading.
One of the simplest ways of increasing the Risk-Reward ratio is by being more selective with the proposed trades. Some proposed trades will provide a small initial stop-loss while others will require a larger initial stop-loss for the same reward. The smaller initial stop-loss will give a higher Risk-Reward ratio.
Another trap for beginner stock investors is in determining the reward level. Since this level is a little arbitrary with some chart patterns, it is easy to be overly optimistic with choosing the highest level possible. Unfortunately this only artificially raises the Risk-Reward ratio, which is not a realistic value and therefore is a useless value. The problem is even worse with trades that follow a trend since it is easy to use a reward level that would rarely ever be reached.
It is better for the beginner stock trader to be somewhat pessimistic in determining a reward level and to only take entries in trades that provide the appropriate minimum Risk-Reward ratio using the pessimistic reward value. As a guide, most good realistic Risk-Reward ratios for trend trades tend to be around 3 or 4. For a price target trade, most good realistic Risk-Reward ratios are in the range of 1.5 to 2. So a Risk-Reward value of say 10 is unrealistic and the stock trader will never make 10 times what they lose.
The spread is a cost for the trader who takes a market order
Beginner stock traders are usually confused about what the market price actually refers to and assume it means the last price paid. While this is true when the financial press reports the closing price (which is simply the last traded price before the markets close), when referring to stock orders the term market price actually means "the best Bid price and the best Ask price" and not the last traded price.
The best Ask price is the lowest ask price currently available at the stock exchange or ECN (Electronic Communication Network). This is the price you can buy stock at when placing a Market Order to Buy. The Best Ask is also referred to as the Best Offer.
The best Bid price is the highest bid price currently available at the stock exchange or ECN. This is the price you can sell stock at when placing a Market Order to Sell.
The spread between the best Bid and best Ask is usually quite small for liquid stocks during regular market hours (9:30 AM to 4:00 PM EST). However during the premarket and after market trading hours the spreads can be extremely large due to the low trading volume typically encountered outside of the normal business trading hours.
There can be several bids at the same price and there can be several asks at the same ask price. For the Exchanges the number of shares are in Round Lots of 100 shares which are normally traded by the institutions. ECNs allow any number of shares to be placed on the bid or ask and are commonly transacted with individual traders and investors even though intuitions may also be involved. With ECNs the shares that are in 100 share lots are still referred to as Round Lots and the remaining quantity that is less than 100 shares is referred to as an Odd Lot.
The difference between the best bid and the best ask is known as the bid-ask spread. Thus if a trader or investor were to buy stock with a market buy order and immediately sells that stock with a market sell order they will incur a loss equal to the spread times the number of shares.
The bids and asks along with the share quantities available at those prices are listed in the order book (also known as a Level 2). The best Bid and best Ask are shown on the first line in the order book.
When an investor or trader places a limit order into the order book then they are referred to as a liquidity provider. This is because they are providing bids or asks that can be filled with market participants who place market orders.
When a market participant places a market order or places a limit order that immediately executes then they are referred to as a liquidity taker. This is because they are removing orders from the order book.
A limit buy order can only be placed into the order book if the limit price is at or below the best Bid price. Similarly a limit sell order can only be placed into the order book if the limit price is at or above the best Ask price.
An example of an order book is shown below in Table 1.
Table 1. Market prices – Level 2 quote
Level 2 quote.
From Table 1. above, the best Bid is the highest bid price which is $20.00 and the best Ask is the lowest ask price which is $20.02.
- The bid-ask spread is $0.02 (20.02 - 20.00).
- If an investor places a market buy order for 100 shares they will pay $20.02.
- If an investor places a market sell order for 100 shares they will receive $20.00.
- If the investor bought 100 shares and immediately sold 100 shares they would lose $2 ($0.02 x 100 shares). This is the cost of the spread.
The cost of the spread has the greatest effect on short-term trading and can significantly reduce the profitability of day trading strategies. As the time frame increases the effect on profits diminishes.
Example: The bid-ask spread from Table 1. above is 20.00-20.02.
- If a trader buys at market they pay $20.02 and if the stock trades up to 5% to 21.00-21.02 and the trader sells at market they receive $21.00.
Even though the market price increased by $1.00 the trader made a profit of $0.98 ($21.00 sell price - $20.02 buy price). Thus the spread cost the trader 2% of their gain.
The following illustrates how the cost of the spread affects the net profitability for different percentage price gains (assuming the same buy price):
Cost of the spread:
- A <>day trader might sell for a $0.10 gain with a market order with the market price at 20.10-20.12 and receives a profit of $0.08 ($20.10 sell price - $20.02 buy price). The spread cost the day trader 20% of their gain.
- A swing trader might sell for a $1.00 gain with a market order with the market price at 21.00-21.02 and receives a profit of $0.98 ($21.00 sell price - $20.02 buy price). The spread cost the swing trader 2% of their gain.
- A speculative investor might sell for a $10 gain with a market order with the market price at 30.00-30.02 and receives a profit of $9.98 ($30.00 sell price - $20.02 buy price). The spread cost the speculative investor 0.2% of their gain.
- A long-term growth investor might sell for a $100 gain with a market order with the market price at 120.00-120.02 and receives a profit of $99.98 ($120.00 sell price - $20.02 buy price). The spread cost the growth investor 0.02% of their gain.
As the above examples show, the longer the time frame then the higher the gain which leads to a lower spread cost. Basically the cost of the spread is only really important for short-term trading as the gains are relatively small.
Performing an analysis on your trades helps improve future trades
The reason for analyzing completed trades is that the stock trader can determine how effective their trading strategies are and how they perform through various market conditions. Not performing a post-trade analysis is the equivalent of driving blind. While at first this may seem like a lot of unnecessary work, in reality post-trade analysis is actually quite simple and quick. There is no need to utilize any complicated analysis techniques and a simple analysis is extremely effective. Post-trade analysis is also useful for active investors who are time their entries or include short-term trades within their portfolio.
The first part to post-trade analysis is to keep a record of each trade completed. At the very least this is needed for tax purposes. Apart from the basic information needed for tax assessment, the stock trader should also record what trading strategy was used and what the general market condition was during the trade.
This information can conveniently be placed into a spreadsheet and should include as a minimum the following information.
- Stock symbol
- Whether long or short
- Entry date and entry price
- Exit date and exit price
- Number of shares
- Brokerage costs
- Net profit/loss
- Summary statement of trading strategy used
Additional information can be added if required but the above list is a minimum that should be recorded for each trade completed.
An example trade summary sheet is shown below in Table 1.
Table 1. Trade summary
This basic information can now be analyzed using a simple ratio known as the Profit Factor.
The Profit Factor is determined by adding up the profit from all of the winning trades and adding up all of the losses from the losing trades.
The Profit Factor is simply the total profits divided by the total losses (ignoring the negative sign).
From Table 1. the total profit is $3039 and the total loss is $634.
Profit Factor = 3039 / 634 = 4.8
The Profit Factor calculation is generally done with every completed trade added to the spreadsheet. If two trades are completed on the same day then the calculation is only done once with both new trades included.
The Profit Factor will vary considerably with each additional completed trade when there are only a few trades to analyze. Once the stock trader has been trading for some time and the number of completed trades' increases, the Profit Factor then varies less with each additional completed trade.
The next simple calculation is known as the %Winning Trades.
This is determined by counting the number of profitable trades and counting the number of completed trades.
The %Winning Trades is simply the winning trades divided by the completed trades and multiplied by 100%.
From Table 1. the total winning trades is 4 and the total trades is 1.
%Winning Trades = 4 / 5 * 100% = 80%
Similar to the Profit Factor calculation, the %Winning Trades calculation is generally done with every completed trade added to the spreadsheet. If two trades are completed on the same day then the calculation is only done once.
The %Winning Trades will vary considerably with each additional completed trade when there are only a few trades to analyze. Also some trades just record a profit (such as the RHT trade in Table 1.) and some trades will barely be a loss.
Another form of analysis is to keep an eye on the performance of the recent trades completed. The same Profit Factor and %Winning Trade calculations can be performed on only the more recent trades rather the all of the completed trades. This is particularly the case when the stock trader is incurring a string of losing trades as this may indicate that the stock trader's strategies need re-evaluating or that the general market conditions are not suitable for trading.
While analyzing a spreadsheet is beneficial to the stock trader, it is also useful to visually examine each completed trade.
A pictorial way of visually analyzing the completed trades is to print out a stock chart of each completed trade. The chart should cover the time frame that the trade was open. Stock traders can then hand write on the printed charts and they can also include all of the spreadsheet information. The charts can be stored in a folder and used as a picture book. An example of a post analysis trade chart is shown below.
Chart 1. Bar chart showing a completed trade
The advantage of creating a picture book of the completed trades is that the stock trader can visually see how their trading strategies are performing by simply flicking through the charts.
The picture book can also be constructed on screen with most charting software packages and the completed trade charts can be stored in a folder on their computer.
The analysis performed so far in this article is considered a minimum for stock traders. The amount of analysis performed is up to the individual stock trader and their personal circumstances; however the stock trader should be realistic with their analysis and some stock traders perform an excessive amount of analysis which quite often is of no real addition benefit. Stock traders should keep in mind that the stock market is highly variable and trading results will naturally vary over time.
Are you aware of your own emotional state of mind
When stock traders are making money their emotional state of mind is positive and they tend to make logical and rational decisions. However when stock traders lose money (especially beginners), they become anxious and determined to recoup their losses which puts pressure on themselves. As a general rule when most people are under pressure their ability to make logical and rational decisions is impaired. This is no different for the stock trader who now starts to make poorer trade decisions. This has the undesirable effect of yielding poor results thus increasing their already poor trading results.
Trading psychology deals with the emotional aspects of stock traders and its purpose is to make them aware of their own emotional state of mind. The term 'professional' is used to describe a person who can think and analyze logically and rationally while keeping their own emotions under control.
Consider a lawyer defending a client whom the lawyer suspects is guilty but the lawyer must make a rational argument in court that the client is innocent of the charge brought against their client. A lawyer is considered professional since they can block out their emotions which is suggesting that their client is guilty. Without the ability to block out this emotion, the lawyer could not make any rational arguments to defend their client.
This same professional attribute that the lawyer displays is what a stock trader needs to exhibit if the stock trader is to be successful at trading. This is where trading psychology comes into play. By understanding the mere fact that emotions compromise the stock trader's ability to reason rationally, this will help the stock trader to block out their emotions.
The human mind is basically wired to think rationally and will do so up and until an emotion takes over. That is, once an emotion takes control, the human mind will now defend that emotion with irrational logic. Any rational reasoning that contradicts the emotion is automatically rejected by the human mind. The emotions defensive capabilities are extremely strong.
Being aware of this emotion allows a stock trader to block the emotion. This is achieved by questioning the emotion with a logical counter argument (similar to the lawyer). Thus the stock trader is effectively arguing with themselves like they have two minds.
As an example, a stock trader who had been trading profitably is now finding that all of their recent trades are yielding poor results with a high proportion of losing trades. A rationally thinking stock trader would question whether the market itself was undergoing a correction. However, the stock trader who is getting hammered by the market is probably fixated on recouping their rather significant losses and as such is in an emotional state where their mind will not naturally perform any logical analysis.
The trick here is to act like a professional and form a two minded argument with oneself - use a logical argument to counteract the irrational thought within your own mind.
Counteract the irrational thought:
- The stock trader's emotion simply wants to make this money back now and it does not care how. The emotions reasoning for recouping these losses immediately is that by doing so it will make the emotional pain and anguish of losing money go away. Of course this is a ridiculously irrational line of reasoning.
- The logical counter argument is - why are these losing trades occurring in the first place - is it because the market itself is correcting and if so then entering more trades at this stage would only lead to further losses - it would be best to wait for the market correction to end before entering any new trades.
Thus the stock trader by being aware of their own emotional state of mind can form a logical counter argument against their irrational emotional reasoning. While this is easier said than done, at least by questioning their emotional reaction the stock trader is in a better state of mind to query it.
The next trick is not to get to such an emotional state of mind in the first place. There are several traits that the professional stock traders exhibit as follows.
Traits of professional stock traders:
- Don't be over confident when having a high success rate of winning trades! The stock market constantly cycles through short-term bullish and bearish phases. A short-term bullish phase will naturally lead to very good results, but this will come to an end and a short-term bearish phase will take over which will produce a string of poor results. Be prepared for it!
- When entering a trade it is easier to ignore the fact that it is actual money the stock trader is putting at risk. After all, the stock trader merely needs to click a button on a computer screen to enter a trade rather than having to physically hand over cash to the broker. Some stock traders can get trigger happy and forget that it is real money they are risking!
- Don't force a trade! If there is nothing worth trading then don't enter a trade just for the sake of entering a trade. The stock market cycles through stages where there is significantly more to trade than what any trader could possibly enter and stages where there is absolutely nothing worth trading. At times the stock trader will be very busy and at other times there is nothing much to do.
- Beware of the temptation to hold onto losing trades! This is a natural emotional reaction and it is human nature. Unfortunately for stock trading it is also a primary reason for traders destroying their account balance. Stock investors get away with holding onto losing investments since the gains on their winning investments far outweigh their losses in the long-term. But for stock traders, their gains from the winning trades are only small and do not cover large losses from losing trades. Selling at a stop-loss is a fact of life with stock trading!
Trading is not rocket science and the average person can readily acquire the knowledge required to trade successfully. The two biggest enemies of the beginner stock trader are a lack of trading knowledge and a lack of understanding their own emotions along with the devastation it can cause to their account balance.