This chart is a good example of why it is important to think about whether you will place your stops in the market OR use chart based stops / mental stops to exit your positions…

Price Spike on a Hong Kong Stock I held in my portfolio

This chart of a stock in Hong Kong shows trailing stops that I have on this position (in blue and yellow) and the price action yesterday. At some point during the day there was a big selloff in this stock and the price dropped as much as 44% at the low of the day.

You might think – “that’s ok, my stops would have gotten me out” but you would be wrong. If you have a position in a stock like this and it moves this suddenly against you then it would most likely blow through your stop and get exited somewhere way down near the low of the day….Believe me, I have experienced this quite a few times!

But look particularly at the closing price yesterday! by the end of the day the price had bounced all the way back up above my stop levels. If you had in market stops then you would have probably sold near the low of the day and taken a heavy loss, but if you had mental stops you would be still in the position at the end of the day and avoided that loss.

1. Place stops in the market:

The advantage of this is that if your position moves against you, your broker will close your position and you will get out of the trade regardless of whether you are at your computer looking at the market or not. This means that if the market keeps going against you the following day, at least you are out of the position and that losses have stopped (hence the term ‘stop loss’ I guess – LOL)

This makes it a great option for people who can’t reliably exit their positions at the close of the market or at the open the next day.

The disadvantage is that when you have stops in the market, every now and then (like this chart), you may suffer a lot of slippage when someone with fat fingers dumps a huge position and pushes the price way down quickly. But hey – at least you are out of your position!!!

2. Use chart based/mental stops and exit only at the close:

This means that your stop may get triggered by the low of the day, but you manually execute the trade to close your position at the close of the day.

The great thing about this is very often (as in this stark example) the close of the day is higher than the low of the day…so you can often get a higher price by closing your position at the end of the day rather than letting your stop get triggered intra-day. You will typically also suffer less slippage by manually placing your exit order (as a limit order probably) close to the end of the day compared to having a sell stop order in the market that executes during the day.

The downside is that sometimes the share price will close at the low of the day and by exiting at the close you may in fact be getting the worst price of the day.

3. Use chart based/mental stops and exit at tomorrow’s open:

The third option is similar to option 2, however, you exit your position the next day at the open rather than today at the close.

The advantage of this is that you give the stock a little more time to recover from the adverse move and hopefully get out at a slightly higher price tomorrow at the open…

…BUT…if the stock price keeps falling then you could get an even worse price and have a bigger loss when you exit tomorrow at the open.

How do you make the decision about the best way to exit?

My students in The Trader Success System will be aware that the only correct way to make this decision is to backtest your stock trading system with each approach and determine which is the most profitable in the long run.

While in this SINGLE example the answer seems obvious, making a decision like this based on one chart is absolutely the wrong thing to do.

Too many traders make decisions like this based on one or two well chosen examples. There is a huge risk in doing this because when you are trading a portfolio you need to think about what works over hundreds of trades…not what works in one particular example.

So how do you do this?

Well using a program like Amibroker to backtest your trading system correctly is a great way to do this. You code all of your trading rules into Amibroker and then backtest the different approaches over the last 20-30 years of end of day data for your markets (and other markets).

Once you have coded your entry and exit rules and each of the three alternative approaches above, you can compare the results objectively and make an informed decision about whether you should use in market stop losses or monitor your positions on the chart and manually exit your trades at the closing price or the following day’s open.

Of course there is quite a bit to learn to correctly backtest your trading system using Amibroker. If you want to learn more about backtesting and objectively evaluating your trading system’s performance then The Trader Success System is exactly what you need.