I want to share a trading strategy with you that involves stop-losses that will:
1. Show you how you to pre-define your risk on any trade; and
2. More importantly, under the right circumstances, it will enable you to use massive leverage without massive risk.
(Point and) Figuring Out Your Stop-Loss
For me, there are two types of stops — stops that I use when I first enter a trade, and trailing stops that I use to protect profits. This article will address the former.
One of the great aspects of point-and-figure (P&F) charts is that support, resistance and breakout points are easily identified.
Below is a chart on China Medical Technologies (CMED).
We got a “sell” alert on this one a few weeks ago over at Sector Hunter when it was trading at $15.89. Since then, it has traded as low as $11.41. This trade is no longer actionable, and I’m sharing it with you for illustrative purposes only.
Let me give you some background on what you are seeing on the chart.
P&F charts measure the battle between supply and demand; demand is represented by Xs and supply by Os. The charts strip out the minor day-to-day moves and only change columns from Xs to Os, and vice versa, after a set series of “box” moves.
The above chart is a three-box reversal chart, with each box representing 50 cents. On the chart, we can see that the most recent column of Os shows a low of $15. It would take a $1.50 move, which would be the same as a three-box reversal from the low of $15 to $16.50, to reverse the stock back to Xs.
(Important note: The box size changes as the stock price increases and decreases. Between $20 and $100, the typical box size is $1; below $20, it’s 50 cents.)
Use the Bull, Bear Lines to Plot Your Profit Points
The blue (Bullish Support Line) and red (Bearish Resistance Line) lines represents long-term support (blue line) and long-term resistance (red line).
Typically, the lowest-risk shorts occur in stocks trading below their Bearish Resistance (red) Line.
Whenever you source a new trading idea, you must attach a stop-loss point to it. In the case of CMED, this was relatively easy to do.
We can see that the last column of Xs was at $16.50, and a move to $17 would be a double-top breakout.
Using a break above a recent price high is a terrific stop-loss tool when going short. The same can be done when going long with the exception that, on a long, you would place your stop-loss right below the most recent low.
By placing our stop one entire box above the previous high, we remove much of the ambiguity of how far we should specifically place our stop above the most-recent high.
If the stock were to tick $17, it would be a crystal-clear violation of the downtrend. It would mark the first time that the stock was able to make a higher high since peaking at $26, and this would be a strong indication that something had changed.
In this instance, the stock was already trading very near its stop-loss point, offering an excellent risk/reward opportunity.
The Tighter the Stop, the Bigger Position You Can Take
However, sometimes a trade will be far-removed from its stop-loss point.
In these cases, I will either greatly reduce my position size so that, if I do get stopped out, I am risking no more than 1%-3% of my total portfolio value. Or, more likely, I’ll bypass the trade and focus on a situation with a much better risk/reward profile.
Remember, the closer you are to your stop, the bigger the position you can take.
Let me explain. Imagine you have a $10,000 portfolio and you are using a 3%-risk rule. This means that, when stopped out, you cap your loss at $300. (Keep in mind that gap moves can and do happen, of course.)
Using the above portfolio example to establish a short position in a stock, assuming that the stock is trading at $15.89 and your stop is at $17, it means that your risk is $1.11 per share. Your risk capital is $300 (3% of $10,000); to find your position size, we simply divide $300 by $1.11, which equals 270.
This means that you can short 270 shares and, if you get stopped at $17, your loss is capped at $300 — or 3% of your total portfolio value.
Now let’s imagine that the stock is at $16.75 and your stop-loss is still at $17. This means that the risk is now only 25 cents per share. Your risk capital is still $300, but your risk per share is now only 25 cents, whereas before it was $1.11. We divide $300 by 25 cents and we get 1,200 shares!
Under this scenario, we get to take a position four times as large (1,200 shares) for the same amount of risk!
Why You Don’t Need a Big Win Rate to Make Big Bucks
If we get stopped out at $17, we lose 25 cents a share on 1,200 shares, or $300. This is a savvy way to rapidly amplify a small trading account into a large one.
When you have a small account, it pays to be patient and wait for situations such as these. If you are going to take on big leverage, then this is a much smarter way to do it.
When you stack the odds in your favor like this, you don’t need a high-percentage win rate to make a lot of money. If we assume an average gain of $2 per winner and average loss of 25 cents per loser, even with an 80% losing rate you still come out ahead!
If you take 10 trades, each for 1,200 shares, and you have eight losers for 25 cents and two winners with an average gain of $2, you would have lost $2,400 on the losers, made $4,800 on the winners and netted $2,400, or 24%, on $10,000.
If you compound $10,000 at 24% a year for 20 years, you’d have a $738,641.50 account.
The most-difficult part of this strategy is having the patience and discipline to only target trades that have the best risk/reward parameters. Most people can’t do it; they just crave the action too much. They invest for emotional reasons rather than financial ones.
When you are really doing it right, your trading should be devoid of all emotion. The highs and lows come from taking on too much risk and not knowing where you are going to exit a trade if it goes bad on you. However, emotional control is a whole other issue that we will tackle another day!
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