6 Steps to Profitable Swing Trading

Part 5.2: Position Stop-loss Tactics

To recap so far, we’ve covered Expectancy (Part 1), Market Conditions (Part 2), Finding Frisky Stocks (Part 3), Setups (Part 4 ), and Entry Tactics (Part 5.1). As you can see, this is a progression of sorts - one step builds upon the other.

You wait for good market conditions, narrow your pool of stocks to only the fastest stocks with the most potential, wait for those stocks to form sound, constructive patterns and pivot levels, and then wait for a proper trigger through the pivot.

You see, while we get into this game thinking it’s all about trading, what we actually we get paid for is waiting. You should think of yourself as more of a waiter, than a trader!

The Market Isn’t Fair

You want to have a plan before you get into the trade. It’s one thing to know the pivot level and actions to take on the buying side, but more importantly, you need to know what to do if the trade fails. AI 0.00%↑ below is a perfect example of why we never want to get lulled into a sense of confidence, no matter how good things seem.

I was super excited about this stock. The market was just turning up out of a funk and AI stocks were an obvious theme standing out among the high RS, high volatility “frisky” stocks. The entry looked great - a nice breakout from a short flag, through the pivot and the upper Bollinger Band. From there, it just went on a tear - up more than 30% in just a few days from entry.

But the party wouldn’t last. Bad news hit the stock and it cratered. Fortunately, I scratched the trade at a little better than breakeven, but some traders froze - those that chased the entry far above the proper buy point were now sitting on large losses. These same traders, thinking that it “has to bounce” off the 20-day EMA, were further wrecked the next day as the stock was down another 15%.

I took this trade and felt the violent swing of emotions - ranging from elation to “wtf just happened”, as I round-tripped the stock from +30% back to scratch. But I didn’t freeze - I had a plan. This stock highlights a few key things:

1. No matter how good the market, how clean the entry, or how positive the stock action after we get in, there are no guarantees in the stock market.

2. Getting in without planning where you’re getting out is a recipe for disaster.

3. Buying right and not chasing a stock past a proper buy point is paramount to keeping risks small.

4. Stops are like insurance - bad things aren’t going to happen everyday, but when they do, you want to ensure you’re protected from disaster.

What does disaster look like? Mark Minervini has what he calls the 50/80 rule of thumb, which states that there’s an 80% chance a leading stock will drop 50% and a 50% chance it will drop 80% once the bull rally has ended and the once leading stocks deflate their over-expansion of price. No matter how good a pattern looks or promising the fundamental picture, you never want to get caught with your pants down.

An 50% loss of capital requires a 100% gain to get back to breakeven. An 80% loss requires a 400% gain to breakeven. How often are you pulling those kinds of numbers? The best offense is to have a great defense.

I’m in - now what?

Although the title of this section accurately describes your sex life (you know who I’m talking to), this is not ideal for trading. I will assume that you’ve bought correctly - at the pivot of a well-formed pattern. I’m also going to assume you’ve internalized the need to protect yourself. So when do you place the protective stop?

Place a protective stop as soon as you buy - every trade, no exceptions.

If you’re confused about why, refer to the table above. This stop-loss amount should probably not exceed 10%, 12-15% at the most. Once you get past 10% losses, the math works geometrically against you. While a 5% loss can be recovered with a 5.26% gain and a 10% loss can be recovered with an 11% gain, beyond that, the math stops mathing.

This is another reason we want a tight contraction area before the pivot breakout. The tighter the pivot, the less your eventual stop can be, depending on where you place your initial stop.

The Psychology of Loss

Traders use a couple of common tactics to place their initial stops. I wouldn’t say that any of them is better or worse than the others - it’s about understanding the trade-offs and knowing what you can consistently deal with psychologically.

• Tight stops - Pros: bigger position size, higher profit factor; Cons: lower batting average, more churn and reentry

• Loose stops - Pros: higher batting average, less churn; Cons: smaller position size, lower profit factor

You have to ask yourself: What can I consistently deal with mentally?

Trust me - everyone has a threshold of pain.

Some people psychologically can’t handle churn and repeated stopouts. As soon as they get stopped out a few times with their tight stops, they hesitate to pull the trigger on the next trade, they start to move their stops to avoid a stopout, etc. If this is you, don’t use tight stops. It’s a recipe for disaster, and you will sabotage your plan.

Other people can’t stand the thought of having wider stops, smaller positions, and letting the stock “wiggle around” a bit while it ebbs and flows. It requires too much patience and gives the stock too much slack. If this is you, then looser stops will probably not work for you.

Stop placement is a balancing act between risk, reward, and what you can consistently do. If you have the patience, don’t mind smaller positions and letting a stock wiggle around within normal volatility, then wider stops will work well for you. If you don’t mind getting stopped out and entering a stock several times before it finally decides to take off, then tight stops are likely fine for you. Know yourself and trade accordingly. The best thing you can do is build a trading plan that suits your individual temperament since that’s the surest way you’ll actually follow the plan when the market inevitably starts punching you in the face. And it will punch you in the face the first chance it gets.

Stop-Loss Tactics

I will start with the tightest stop placement tactic and work my way to the loosest stop placement tactic. As I explain these mechanisms, think to yourself which one best suits your personality and temperament. Below, I explain the 1) entry bar stop, 2) pivot low stop, and 3) volatility stop. Are there more options? Sure, but this is enough to get you started and cover the basics.

1. Entry bar stop - the trigger bar breaks above the pivot/trendline. Stops are placed at the low of the entry bar. I typically use the lows of the first 30 or 60 min candle (or the low of the day, if you use daily bars).

2. Pivot low stop - the trigger bar breaks above the pivot/trendline. Stops are placed at the lows of the most recent swing low. Think Point 3 in the 1-2-3.

3. Volatility stop - the trigger bar breaks above the pivot/trendline. Stops are placed at the lower Bollinger Band. This theoretically puts the stop outside recent volatility swings of the stock since the lower band is two standard deviations away.

As I stated above, going from tightest to loosest, there are trade-offs you have to deal with. While Part 6 will deal with position sizing and risk management, know that the further away your stop is, the less likely you’ll get stopped out, but the smaller your size will have to be to account for the extra distance between entry and exit. The tighter your stop, the bigger your size will be, but the more likely you’ll be stopped out and have to plan for re-entry. Choose the tactic that best suits you, but stick with it.

The other tip I’ll offer is, personally, I tend to adjust my stop tactics based on market conditions. When the market is great, and expectancy is high, I tend to go with a tighter stop. The likelihood of the stock following through is high and the likelihood the stock will come back all the way down and undercut the lows of the day is low. Considering good windows of opportunity don’t last forever, I want to push exposure and take advantage of the best moves with the biggest size.

Conversely, when the market sucks, and expectancy is lower, I err on the side of looser stops. I know this goes against some top traders’ advice. Still, I’ve found, for my temperament, I’d rather have a smaller size and looser stop to make up for the drop in batting average that accompanies a poorer market environment. Because of the poor conditions, there will be fewer setups, even fewer triggers, and the ones that do trigger will likely be sloppier and more volatile than normal. Using tight stops in a poor market will almost certainly grind you to a pulp. Using looser stops doesn’t necessarily add more risk, but decreases my aggravation-to-profit ratio substantially.

Practical Application

1. Wait for a good market backdrop with positive breadth and constructive action in the indices.

2. Narrow your pool of stocks down to the friskiest stocks with the most potential

3. Out of that pool, wait for constructive patterns - refer back if you forgot.

4. Once you isolate the best patterns, wait for a tight pivot area of at least 3-5 days where the stock contracts significantly in relation to it’s normal movements. As I explained before, you can do this visually or use tools to quantify it.

5. Wait for a breakout or expansion out of that contraction area. Preferably, you want the breakout bar to be the biggest, greeniest bar in the last 5-10 days. If you don’t want to pay up for confirmation, then anticipate, but based on experience, there are trade-offs to this. Trying both ways, I’ve come to prefer paying the insurance.

6. Immediately and always set a stop on every trade, no exceptions. You can use the same bar, pivot lows, or a volatility stop. I recommend using whatever suits your personality and temperament.

Wrapping it up

There you have it, waiters. In Part 5.2, we’ve discussed trade stop-loss placement and different trade-offs associated with each. In Part 5.3, we will discuss different trade management strategies, including bar by bar, profit/loss targets, pivot trails, moving average trails, and the tradeoffs associated with each method.

Stay Tuned!!