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During the last week, I received an email from a long time subscriber asking whether I could write about stop loss orders and whipsaws. Evidently, he was placing stops regularly and getting stopped out only to see the position reverse position after he was out and take off. This complaint is one I have heard many times over the years. Many factors can influence the placement of a stop loss order, but the great majority of traders who are aware of support and resistance levels and of trends tend to place stops in roughly the same place. Market makers are generally bright people or they would not continue to be market makers for very long. They are aware of the tendency of retail traders who do place stops to place them in the same general areas. Stops are also visible to the market makers so they know or have a very good idea of where the orders are clustered. It seems that what often happens is that the stock price is often taken to that area where there are numerous stops, the stops are hit, someone buys the stock and then it takes off.

What can a trader do to avoid this frustrating and often costly dilema? That question does not have an easy answer if a stop loss is going to be placed. Choosing the level is very subjective. Anyone familiar with technicals can see, for example, where a support level lies and can place the stop below the support level. The difficulty is where below the support level the stop is to be placed. If we assume the trader is bullish, he obviously wants the stock to go up, but also wants to exit a play that is going south by incurring as small a loss as possible. As far as I know, there is no magic formula. The trader, like the market maker, should have a pretty fair idea of where the retail trader will be placing stops and must realize that if the stock is going to be taken to that level there is a high probability of being stopped out. Perhaps the trader could choose to place the stop even lower than where he suspects the great bulk are sitting. In that event he would expect to escape the whipsaw, but would run a risk of losing more if the stock price were tumbling for real.

I believe stops are important for most traders to use because they help remove the emotion from trading. Many people will set an alert, but then fail to act if it is hit. If the trader is disciplined enough to set and follow the alert or have a plan in place before the alert is hit, he may have a better chance of avoiding the whipsaw.

Personally, I prefer to set an alert, and when it is hit, watch the stock's behavior in terms of both price and volume to see whether it is really falling or whether it is just a head fake. Admittedly, I do expose myself to some greater risk on the downside with that method, but often I am able to enjoy the run-up after the dip.

Good Trading!
Bill Kraft

Mr. Kraft's past articles are posted on our website for your review.

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