Invest and Trade Profitably with Jon Johnson

You had a question about trailing stops. Your answer was good so far as stop loss orders are concerned. However, it seems to me that the stops set a certain percentage behind the market price (or a certain number of points) was not addressed. e.g. NXTL closed today at $17.32. A trailing stop one percent behind would be set today at $17.15. If NXTL goes up to $19.00 tomorrow, the stop would automatically rise with it to $18.81. If I understand it correctly, the order would be activated if, and when the price dropped one percent from its high. Is this understanding accurate, and when would this strategy be appropriate? Perhaps on a skyrocketing stock that may fall just as suddenly? Or when you want to keep stops really tight?

August 30, 2000

Trailing stops are more art than science. You are balancing two similar goals: maximizing the gain while letting a winner run for you. Too tight and you are stopped out on ‘normal’ volatility on a run. Too loose and you can loose a big chunk of a gain on a stock that takes off on a ballistic run for a week.

If a stock breaks out and is in an uptrend as many, many of the stocks on the report are, we are playing that trend. As long as that trend is in place we are willing to let the stock move up and down inside that trend. It can even undercut the trend on an intraday basis, recover on the close, and go about its merry way back up. In that situation we want to use the support as our trailing stop point. That means putting stop losses below the 18 day MVA if that is what it is using in the trend. If it breaks the trend on volume heading into the close our trailing stop will be there for us to use. Typically we use mental stops as opposed to entering them during a strong trend; that way we don’t get taken out by an aberrant day. As things get more volatile toward the end of a run we may go ahead and insert one into the system, but there are a lot of pitfalls in doing that, particuarly if your stock or option is not very liquid.

One stock we were just playing was XING. We caught it on the breakout around 5.75 and it screamed up to almost 14. We took some gain on the way up and then let it run, inserting a stop loss. Because the move was so ballistic we inserted a trailing stop well over the 10 day MVA because we know such a strong move will give back a lot of the gain. We wanted to capture the gain so we moved a stop way up under it. That is one of the situations you addressed. If you have a huge gain (here over a double), go ahead and take it because you know it cannot keep that trend for long. We can then catch it after it falls back. Indeed, XING held the 10 day MVA Thursday and edged back up.

The last situation you mentioned is similar to what we were using in the very choppy market early in the year as well as other times during the bear market when there were rallies we could take advantage of on the upside. Those can reverse on you rapidly. We would give plays we initiated some room to work, but once they built in a gain for us we would keep tighter stops as one day of reversal could wipe out a few days of steady gains. In that situation we tried to gauge the usual intraday movement of the stock and place a trailer just below that level. If things got too dicey we would just close the position and take the gain. Why? Because there is no established uptrend in the market, and we do not delude ourselves into believing that upside stocks in a bear market are going to escape the market’s wrath.

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