Stock Trading

Where's the Stop?

Definition of a Stop

We've written previously about how to choose a stop level, and are going to expand on that with this article.

A stop price is the point that you determine your "story" for a trade was wrong. At that point you have no reason to remain in the trade and should exit. The more you can make the process of taking a loss become automatic, the smaller your losses will become, and the easier it will be for your winning trades to outweigh the losers.

Stops are the most essential weapon in your trading arsenal. Without them you can't determine a trade's reward-to-risk, and thus, whether you should even make a trade or not.

Being that stops are so important, it is imperative that we place our stops at levels that stand a fair chance of not being hit on a typical pullback, but trigger when a trade has clearly gone south.

Where to Place a Stop

There are certain levels on our charts that make good stop levels. Essentially it comes down to finding areas of the chart that are below levels that have previously found buying interest—known as support levels. The belief being that buyers will continue to buy at these levels on subsequent drops. With our stops below these levels, instead of just above, we stand a better chance of remaining in the trade if it rebounds, but also of closing the trade out if it continues lower. Let's take a look at the most important levels to watch in order to place our stops effectively.

Previous Lows

Previous lows are important levels because they show us where buyers arrived during the earlier drops in the stock price.

In the chart of Amazon you can see that after a strong uptrend following the COVID market lows, the stock pulled back to $2871 in September, traded sideways for a few months, dropped back in March, but found support just above that level again, and has since rallied a bit.

This level provides us a very clear stop level. If you were currently long AMZN stock a stop below $2871 would be prudent. Our assumption would be that a break below there would continue lower, since the buying pressure found at the support was broken.

AMZN-Previous Lows

AMD's chart shows us a nine-month series of lows very near $73.88. After four solid tests of this level, a break below it would be a significant achievement for the bears, as the bulls have found supportive buying there so many times. It's worth noting that support was broken slightly in May, with a low of $72.50. This often happens as bears try their best to generate selling pressure and drive the price through support. Support levels like this are rarely exact, so your stops do need to leave some room for this possibility. If you were long AMD currently, your stop would be below the $72.50 low.

AMD-Previous Lows

Moving Averages

Moving averages are levels that are closely watched by technical traders. The most commonly watched are the 20-day, 50-day, and 200-day, but some traders find others useful as well. Regardless of which you use, you'll often see that a stock finds support at these levels. Therefore, a break below them could be used as a solid stop price.

In the chart of CAT you can see that the 50-day moving average (red line) has been repeatedly tested throughout the year while it rallied in a strong uptrend. While the 50 won't stop the stock dead in its tracks, CAT still hasn't managed to fall very fall below it. A stop would be placed below the 50-day moving average (50-DMA) with enough room given to allow it some amount of wiggle room beneath the line.

MAs

In the case of MMM the 200-DMA (gold line) was acting supportive before the stock took off at the beginning of the year. Since then the 50-DMA (red line) has been tested, and held, a couple of times. If you were riding this uptrend you would use a solid break of the 50-DMA as your stop, as once that level is broken it would appear likely it was going to drop to test the 200-DMA again.

MAs

Trendlines

Trendlines are nice to see, but are rarely exact. They are more often a "general" trend, and therefore the trendline you draw usually tends to be a little creative. Here's a primer on drawing trendlines. When in a trade you obviously want to see the higher trend continue. Using these allows us to get a good idea at what point that trend has failed, and allow us to get out before the inevitable deeper pullback.

The DKS chart below is a good example of an uptrend. It's clear as can be that the stock is in a strong uptrend, but you can also see that there was a period in the middle that broke that uptrend for a while. That particular pullback failed to make much headway before the uptrend continued. However, the stock has now run a long way, for considerable gains, and you'd likely want to respect a break of your trendline, and exit at that time. But as long as that trend is intact you could comfortably continue to ride it higher.

trendline

AAPL's recent uptrend hasn't resulted in any headway towards new highs, but it has resulted in a very clear series of higher lows. This is sort of an "uptrend in the midst of a consolidation" which is also known as an ascending triangle. These chart patterns tend to resolve themselves with breakouts to new highs, which is why you would want to place your stop below the trendline. If that level is broken it means the ascending triangle pattern is also broken, and the trade isn't playing out the way we believed it would.

AAPL-Trendline

Day's Low

Occasionally, you'll get a winner that really takes off, leaving all obvious support levels well behind it. In this case what we'll often do is move our stop up to a previous day's low—a low made a day or two earlier. One good option in this situation is to place a stop for half of the position below that level, and half of the position at a lower stop.

In the case of the Ford (F) chart below you can see that over the past two weeks the stock has run a lot higher. Whereas you were likely using the moving averages for a stop, the stock has now moved so far away from them that that would no longer be reasonable. In this case you may begin moving your stop up to a previous day's low. For the past seven days this level would have held and allowed you to remain in the trade as it ran to the current highs.

Days Low

Conclusion

Choosing a stop level is as much art as it is science. It's difficult to know how far a stock might fall, but we want to prepare ourselves to be out of the way as soon as it seems reasonable that the fall could continue further. Support levels in the forms discussed above often provide us with the early clues needed to avoid getting hurt on a trade. By entering a trade close to these important levels we maximize our reward-to-risk, and by placing our stops just below these levels we manage our risk effectively. Small losses are a part of a trader's life, and using stops is what keeps them small.

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