Technology is changing the face and structure of global commerce, from the way we shop, to the way we travel, to the way we buy and sell stock. Even the stop order—one of the basic building blocks of many trading strategies—may require a rethink due to technology.
Technical Analysis Meets Darwinism?
Although it’s not a living entity, the characteristics and peculiarities of the stock market are in a constant state of evolution. Strategies that worked yesterday may not work tomorrow. The speed of this evolution has increased greatly over the last decade with the introduction of high-frequency trading (HFT) and algorithmic trading (“algo”) programs, which often account for the vast majority of total trade volume.
One of the byproducts of this mechanized trading is the tendency to push stock prices toward areas of support and resistance where pockets of volume sometimes “hide” in the form of standing stop-loss orders. Many traders say they’ve witnessed an increase in this phenomenon over the last few years— price comes right down to your stop-order price, and after it’s triggered, the stock quickly reverses. This can be one of the most frustrating things for a trader to experience, but there are some ways you can try to protect against it.
Hunter and Prey: Hiding in Plain Sight
Let’s first look at a hypothetical trade to better illustrate the problem.
After several attempts, XYZ stock rallies above a resistance level of $50 and you decide to buy it at $50.25, placing a protective stop order at $49.75—below the former resistance level, which many technical traders would now view as a support level. The price continues to $52.50, but then stalls and begins to pull back. The stock continues downward until it hits your stop at $49.75, and then bounces back above $50.00 and continues moving upward, eventually moving back above $52.50.
Often, when a move like this happens, some traders will scream, “They went after my stop.” Leaving aside whom “they” refers to, this statement may be only partially correct. There’s no venue where your stop order or anyone else’s can be seen. But it doesn’t take a rocket scientist to know that when a former resistance level is broken, traders will naturally place their stops below it. That’s also how HFT and algo programs are designed to think. (In fact, some of these firms actually do employ rocket scientists.)
To avoid getting prematurely stopped out of a position by the noise these trading programs create, you must evolve how you place your stops. Here are a few strategies you can experiment with. Before using stop orders, keep in mind that they are not guaranteed to execute at or near your activation price.
Adapt with These Strategies
1. The Stop Plus: A sound trading methodology can be based upon sizing your position in relation to the distance between your entry price and your stop price. With this method, you might add 25% to that distance.
Entry price = $50.25. Stop loss = $49.75.
$50.25 – $49.75 = $0.50 stop
$0.50 + 25% = $0.63 stop (rounded up from .625), for a stop-order price of $49.62
Implementing a sizing strategy like this might mean reducing the number of shares you trade, but maintains the same dollar risk and might help you avoid being whipsawed out of your position.
2. Anticipating the Stop (a.k.a., “Waiting for the Flush”): This method involves a bit of judo, flipping the script and anticipating the run of the stop orders.
In this case, you won’t buy when XYZ breaks the $50.00 level the first time. Instead, you anticipate that, after an initial rally, the price will come down below the breakout price to “clear the stops” before bouncing. So, you would put a limit buy in just below the $50.00 level and wait for the presumed pullback.
One drawback with this method is that, sometimes, the flush never comes, but rather the stock keeps rallying. If that happens, you’ll have missed the trade entirely. But the advantage is that if you do get filled, you’ll have a lower entry price. This method can also give you an opportunity to see if the $50 “support” level holds.
3. Half and Half: This last method is a hybrid of the previous two and is designed for those who don’t want to take a chance on “missing a move.”
In this case, when price rallies above $50.00 the first time, you’ll only buy half of your target quantity. Then place an order to buy the other half just below the support level. In this scenario, if the stock breaks out to the upside and just continues higher, you won’t miss out entirely, although you will have a smaller position. And if price comes back down to challenge stops below support, you’ll fill out your full position, perhaps at a lower average price. But remember: this strategy will rack up more transaction costs.
A great way to find out which of these strategies works best for you—or to discover another variation that might fit your trading style—is to test them out using the paperMoney® platform on the thinkorswim® platform from TD Ameritrade. It has all the functionality of the live platform but allows you to experiment as much as you want without risking a dime.