CHAPTER 19
Placing Stops
Basically, two ways can determine where to place a stop, both in relation to the
entry price and in relation to the current price of the market. Furthermore, there
also are two very wrong ways of doing this. Unfortunately, these two very wrong
ways also are the most commonly used methods. Therefore, let’s talk briefly about
the very wrong methods before we move on to the two methods we will use for the
remainder of this book.
Wrong method No. 1 is to assign an arbitrarily chosen dollar value to stocks
trading within a certain price range. For example, I recently was asked to test a
system that had assigned a $2 trailing stop to stocks trading within the $5 to $10
price range, a $3 stop for stocks trading between $10 to $20, and so on. For stocks
priced over $50, the system called for a 10 percent trailing stop.
Thus, for a stock trading at $5, the system developer thought it was wise for
you to risk 40 percent (2 / 5 0.4) of your invested capital in one trade, but “only”
10 percent for stocks priced above $50. Why? What’s the reason for this discrep-
ancy? True, lower-priced stocks at times can be more volatile than higher-priced
stocks, but does this justify taking a 300 percent (40 / 10 1 3) larger risk in
the low-priced stock? If so, will the profit potential be 300 percent greater as well?
Nobody knows, and no matter what, allowing a trade to move against him by 40
percent is not the hallmark of a good trader. Heck, allowing a trade to move against
him by 10 percent isn’t the hallmark of a good trader, either.
Even within the same stock-price bracket, the difference in risk is as much
as 100 percent [(2 / 5) / (2 / 10) 1 0.4 / 0.2 1 1 100%]. And what
about those stocks that fluctuate back and forth between two brackets? For a stock
fluctuating around $10, for example, the risk could either be 20 percent (2 / 10 207Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.