THE BREAK-EVEN STOP: ONE OF A SHORT-TERM STOCK TRADER'S BEST FRIENDS
I would like to address a technique that I've found to be one of the most useful available, for the short-term stock-trader's arsenal: the break-even stop. Simply put, once you enter a stock, long or short, [setups/entries are another topic] with a break-even stop philosophy you are looking to "work" your stop [whether a mental, or an actual stop; another topic) to the "break-even" (entry) point as quickly as possible. Not too quickly - the trade needs time to move in your favor. Instead, at just the correct (proper) time, which you can gain a sense for.
Typically, depending upon the volatility of the security you're trading (which can be easily quantified by computing true range on the daily chart bar, or looking at the 3-day average true range - ATR), your initial entry stop might be 1 pt. away or less. To apply a break-even stop, once you enter and the position moves in your favor 1 pt, your stop moves up or down 1 pt to the 'break even' (entry) price. At that time, you have essentially created a zero-risk situation, a "free trade". You are free to take your profits wherever, all at once, in pieces, etc. -- but the main thing is, even if you're stopped out, you haven't lost - at most, you've suffered a tiny nick. There are many ways to manage the position once you're in at break-even or better, a state that I always covet upon entering a trade!
Which makes this a good time to introduce my first three rules of stock trading, which I've developed after careful thought and reflection, during my first five years of trading:
1. DON'T LOSE MONEY!
2. DON'T LOSE MONEY!
3. DON'T LOSE MONEY!
Get it? This all ties in to the "Equity Curve Tracking" concept. If you can consistently keep your losses small, which is what the break-even stop is all about, you set yourself up for success.
When you lose money, you set back your equity curve - you go backwards. Then, you have to make that back, to get back where you were. This is all wasted time. The only thing that is necessary, is small losses. That is why it is so much more lucrative, over time, to trade with small losses. Common sense, right? But, for most traders (myself included) it takes a long time to fully "get" (believe and internalize) this simple, powerful concept, and to apply it consistently.
There are many ways you can apply or refine the break-even stop. I like to set the break-even stop an eigth or a sixteenth above (longs) [or below, for shorts] the entry point, so if I'm stopped out, I've covered commissions (I hate losing, and psychologically I find this better to take a micro-profit). If you start using this technique, you may at first be uncomfortable with it, finding yourself stopped out at break-even as much as half the time (or more). Get used to it - those are trades you previously would have lost money on! Many top-drawer stock traders trade that way - it takes some getting used to. And remember, YOU CAN ALWAYS RE-ENTER. Think nimble.
As for taking profits, I like to leave that discretionary. I am always trying to gauge the true strength of the stock [another topic], and exit into strength or at least as the issue plateaus into resistance (encounters mild selling pressure), vs on a pullback where you must "give back" more. Often it's as simple as (preferably) offering the stock out or (if you're a little too slow) "hitting the bid" when an issue stops trending and starts to consolidate sideways. At other times, you might want to hold a stock that moves sideways, because strong stocks often consolidate by going sideways (instead of pulling back), before they move up again.
Many of the most skilled, seasoned pro's recommend taking your profits in pieces, using a trailing stop on the final lot. I don't like using trailing stocks because you have to give too much back (I try to be gone before they're needed), but they can be a very good idea, if you're not nimble enough to get out sooner - which still happens to me all the time.
Although selling a piece once the position moves in your favor requires multiple (exit) commissions, I've found it very psychologically helpful, in managing the trade, to take off at least a third of the shares once the position runs in your favor. Depending upon market conditions, the stock, the chart, etc. this could occur anywhere from 1/4 point away from your entry point, to a point or two. The point is, you've "locked in" a profit. With that profit "booked", you'll find that you're quicker to obey your break-even stop, since you won't want to give back the booked profit. Again, all positive self-imposed "trade psychology", working in your favor.
Which brings us to another frequently-cited rule: "never let a winner turn into a loser" (in other words, "use break-even stops"). This is a GREAT piece of wisdom for stock trading, which can prevent a lot of losses. This is what the break-even stop is all about. I suggest, for those inclined to try this, to try trading stocks with the objective of "getting into a break-even position" once you enter; make that the objective, not so much your profits - they will come naturally. You'll find the downside evaporates a lot of times. Remember, many of the best stock traders are stopped out at break-even on half (or even more) of their trades. That is a victory! On the bad entries that go strongly against them, they might typically lose 3/8 or 5/8, up to a point, but those are rare. So, by applying this you can have a lot of small losers, and a number of potential winners. And, that's the formula for trading success.
Good trading, -Steve |
