Building a Better Stop

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  • on September 3rd, 2011

There’s always a part of my game that needs work.  This year it has been re-entry, and it’s needed MAJOR work as I’ve been prone to going into preservation mode and not coming out fast enough.  We all know the primary use of stops is as a protector for our capital, but without a solid plan for re-entry it’s easy to forget we’re in this to win big…not just “lose small”.  For me, each new attempt after being stopped out became more difficult to follow.  As the great philosopher George W. Bush once said, “Fool me once, shame on you.  Fool me…you can’t get fooled again.”  Or something like that.

But markets are an exercise in persistence…sometimes they need to fool everybody 3 or 4 times before clearing the way for a major pattern to play out.  Every single run starts with a thrust; not every thrust starts a major move.  Never knowing which thrust is going to be “the one”, shouldn’t we make an effort to participate each time the thrust begins?  Since that becomes the point of lowest risk/highest reward, the answer for me is a clear “Yes!”

Agreeing to the above statement requires acknowledging that I will not be afraid to re-enter after 2 or 3 or 4 failed attempts.  I have found this very hard to execute, so like others I usually move on to another stock just when this one finally makes the move we doubted it ever could.  That’s fine in a universe of thousands of stocks; not so fine when we’re executing a model based on $SPY or $IWM or another big index.  We have to be willing to try again.  How?

Every idle moment of my summer has been devoted to this question.  The answer for me has been the use of stops and re-entries based on breadth instead of just price.  It goes like this…evidence tells me to be long, and the number of stocks with rising trend scores is higher than it was yesterday.  $SPY breaks yesterday’s lows but my universe of active stocks still shows more stocks improving in trend.  I follow the broader signal rather than the narrow, keeping me away from noisy price breaks.  If and when stocks confirm, I honor the stop.  I always believe the evidence across 400 stocks…a “break” of a level in $ES_F stared at by thousands of traders?  Depends on the context.

Sometimes stocks lead the $SPX, sometimes(like this week) they don’t.  What they won’t do is stay bullish while conditions deteriorate, or bearish while conditions improve.  After years of leaning towards it, I now have a completely rules-based process in place for both the exit AND the re-entry(or even reversal).  The greatest benefit to watching Peter Brandt chronicle his thoughts has been the intersection of conviction and respect for capital; I had grown to lean too much on the latter and not enough on the former but he nudged me back into balance.

This has been the biggest leap for me in years.  The most important part of a methodology is that we follow it every time.  Executing a stop order is easy.  It was part of the plan, so admitting failure is already built into expectations.  Re-entry, however, is part of another plan, a plan not even devised yet.  I needed a blueprint that had me planning for re-entry before the frustration of my exit even triggered, and a breadth-based model was the solution to break me out of some deeply sewn habits.  As is often the case, for me failure contained the seeds of success.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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