How to make stop-loss work? Part 1: The mechanisms

        

Earning Channel

 

“Let profits run and stop losses short” is a golden rule for successful stock investment.

 

When you fail to exercise stop-loss you may feel some kind of pain inside and you may question your willpower. If you fail often enough, you may suffer overwhelming losses and may lose confidence entirely.

 

The problems with ineffective stop-loss are more in the causes than in the execution.

Why don’t people exercise stop-loss?

  • Ignore price movement, only concern
  • Misperception of “prices lead fundamentals.”
  • The mindset of a gambler. Act according to gossips. Chase a few ticks.
  • Buy dream-stocks.
  • Buy on the way down, flattening or bottom fishing.

Why isn’t the execution of stop-loss effective?

  • Self-center. Value things based on personal cost.
  • Horizontal vision. Set and adjust stop losses horizontally.
  • No automatic mechanism.

How to exercise stop-loss effectively?

  • Matches the fundamentals with price movements.
  • Don’t bet against the flow of the price movement.
  • Automatic channel trading.

 

Stop-loss, in general, is to sell below cost to prevent further damage. Which means mistakes were made somewhere between buying, holding, and selling.

 

The major mistake that results in a stop-loss is that the stock is bought incorrectly, with the wrong valuation, in the wrong direction, or at the wrong timing.

 

Secondly, most people don’t know how to take profit and hold until it becomes a loss. In addition, many compounded their losses by buying on the way down to average their costs.

 

The third mistake is that people don’t have a correct mechanism to execute stop-loss.

 

In this article, we’ll discuss the easier part, the proper mechanism for stop-loss.

 

The common reason for not having a proper mechanism stems from the incorrect visual memory. Most people have two prices in mind: their own costs and the price at the previous top.

 

Since the two prices are fixed, people tend to view the support line and resistant line horizontally. This is what people learned from books and TV, as many TV commentators drew their lines horizontally. When depicting tops and bottoms, those so called experts also drew horizontal lines for tops and necklines.

 

In reality, when the price is on the way up, the support and resistant lines are tilting upwards. When the prices are on the way down, these two lines are slanting downwards. You should act based on these two lines.

 

When viewing price movement horizontally, the stop loss setting is often ineffective. Let’s explain why in two scenarios.

 

Scenario 1: Fixed stop-loss point

Scenario 2: Hand adjusting stop-loss points

From the figure above and our 20 years of servicing ordinal investors, we learned that most people have the red lines in their minds. They always wish the price to be back to T2. Many ignored the fact that the upward trend had been broken. When the price dropped to below their costs, their thought they were still protected by their original stop-loss points. Unfortunately, when the price finally reached their original stop-loss points only a few could carry out the stop-loss. Most still held on to the stock and wished the price will come back someday.

 

Many have the perception that never sell never lose. Or, the loss is only on the paper. Some convinced themselves that this is the exact tactic to outperform the institutional investors, by not selling on the way down. This tactic is recommendable only when the drop is caused by a short-term chaos. Most of the time when the price dropped after a huge gain it did not come back. For the lucky few that do come back, it might take a long time.

 

For those who only set original stop-loss point, they would go through severe ordeal when the price dropped after a long gain. For instance, instead of just rising in two waves to T2, the price rose in 10 or 20 waves to T10 or T20. Many investors lost their opportunities to take handsome profits because of the horizontal visualization.  They do not know when and how to take profit.

 

Scenario 2 is for those with more experience. Those who know how to adjust the stop-loss along with the price movement. However, if the adjustment is done horizontally and manually, it often does not help you to secure the handsome reward, for the following reasons:

  1. Price movement is irrelevant to personal cost nor to the original stop-loss point.
  2. What is the basis for profit-taking? At cost * 1.15? Shouldn’t we let the profits run?
  3. How to adjust? Based on the previous tops, necks, or dips? A randomly adjusted stop-loss point could fall on a channel-buy-point, which, in fact, is a good time to buy and not to sell.
  4. Most people stopped doing their adjustments after the stock had a substantial gain. But, when the price movement finally reversed and started to fall, they lost their reasoning and acted randomly.

 

In fact, with the correct method, you can execute stop-loss without twisting your mind or consulting a psychologist. You don’t even need to resort to your high school math if you have a proper tool.

 

  • The easy and correct way is to use channel trading to carry out both profit-taking and stop-loss. As follows:
  • Establish a long position in an upward channel. Or, a short position in a down channel.
  • Sell some at channel-sell-point to pocket some profits, in case the price does not bounce back into the channel.
  • Increase position at the next channel-buy-point.
  • Adjust position at the next channel-sell-point. However, if you have accumulated up to your planned position, stop adjusting, just hold on to it, until the channel breaks.
  • Use channel break-up line to protect your major gain, especially when the price has gained a lot.
  • Use channel break-down line to protect all long positions. Clean when a long-term up-channel is broken.

 

Whenever you increase your position, please remember to protect yourself with stop-loss point, channel sell-point, and channel break-down line.

Notice that the settings of profit-taking and stop-loss are based on the price movement which reflects the direction of collective cost, not personal cost or any fixed price point.

 

The most convenient dynamic adjustment is channel trading. It works for all stocks and ETFs.

 

Earning Channel is a systematic implementation of channel trading. You can select the channel boundaries based on the monthly, weekly, or daily chart. You can then adjust the default channel trading lines or just use the default settings. After you set the 6 channel trading lines, the system will automatically alert you the optimal timing to trade. This means, it does the math for you and tell you when to act. But you are the one that decides the higher level reasoning: the time scope, the channel shape, and the adjustment.

 

The setting and execution are in the “action plan” of Earning Channel. The mechanism can be applied to stocks in any country.

 

Please refer to the following as exercises. You may notice that our forecast for SPY was remarkably accurate for several weeks.

 

“How to deal with SPY”

“Utility Stocks – Some say buy, we say beware.”

“What to buy now? How about Coca-Cola?”

 

The most important suggestion is to practice channel trading. You should give yourself at least one month in practicing.

 

Please download and practice. You will become a winner in stock investment within a few months. You wouldn’t need to read tens of articles every day or watch if those TV experts happened to talk about the stock you are interested in.

 

Hope this discussion is useful to you.

 

Good Luck!

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