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How to Optimize Stop Placement in an Ever-Changing Market

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June 2, 2015

If there’s one constant about the stock market, it’s that it’s always changing.

The underlying mechanics of the market, as well as the economic factors and investor sentiment that drive those mechanics, never cease to evolve. This includes who’s participating, and the newest recruits continue to be high-frequency trading firms that rely on algorithms and other computer-driven decision-making. All these dynamics require traders to be always thinking one step ahead, especially when it comes to stop placement.

It's also true that placing stop orders can help limit the emotional side of trading. Ever find yourself simply willing a losing position to go higher, often to be disappointed? Or, perhaps you adopt tunnel vision on a specific security that can prevent you from seeking out other symbols.

Now, you may hear these market “stops” also called “stop losses,” which helps to define what we’re talking about. Stop placement refers to the chart point you preselect to jump out of your position to potentially limit losses. Keep in mind that twitchy markets don’t always fill our orders exactly where we place them. Still, stop placement is a common risk management tool that, when paired with predetermined position size, can sometimes help you live to trade another day. It can be important to trade securities with robust volume and liquidity, including tight bid/ask spreads, so that your stop orders don't invite too much slippage when executed.

What’s Different?

Over the last few years, as high-frequency and algorithmic trading firms have become more sophisticated and have leveraged technology more effectively, they’ve become adept at finding pools of price liquidity and targeting them for trading opportunities. These pools, not surprisingly, are often located in areas where stop placement is evident. The most obvious spot is below a support level.

It’s a common strategy for traders to buy a stock after it hits a previous support level, and then hold that level to play a potential double-bottom bounce. Once such a position is initiated, the stop is placed just under the support level. The idea is that if the price goes back down below that support and hits the stop in the process, it means a downtrend is in effect (instead of a double bounce).

Meanwhile, high-frequency and algorithmic trading programs are very logical—almost Spock-like—and have “learned” that stops accumulate in areas right below support, creating the liquidity these trade groups need to be effective. As a result, it’s commonly believed that they attempt to drive prices into those areas. This is an artificial move designed only to run the stops, so once they are cleared out, the price often heads back up above support (figure 1).  

FIGURE 1: FALSE BOTTOM? In the chart above, the price holds at point A and again at point B, forming what looks like a classic double bottom. However, before heading upward as expected, it then takes a suspicious dip below support (red line) into an area where stops are likely placed. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

What’s a Trader to Do?

These shenanigans (legal, sure, but shenanigans nonetheless) can make it difficult, if not impossible, to trade some of the bread-and-butter setups that individual traders make their livings on.

What to do? You might think differently about your buy points, which will enable you to place potentially more effective stops.

Sticking with the double-bottom trade example, you might tweak your stop placement to minimize or eliminate the chances of getting knocked out of a trade prematurely.

If you are sizing your position in relation to the spread between your entry price and stop price, you can adjust your position size down slightly, which lets you buy at the same price but lower your stop to a less obvious level. The capital risk on the trade remains the same. How far down you adjust your stop will depend on the characteristics of the stock you are trading. Start by experimenting with a fixed percentage of the stock’s Average True Range (ATR) and adjust depending on your results.

Another method is to anticipate the run of stops below support and place your limit buy there instead. You could also break your position into two or three limit buys below support. Once again, experiment with individual stocks to optimize your buy points.

Beat the “Fakers” at Their Game

A hybrid of these two methods is to buy a half position at support and place the second half with a limit buy below support. This ensures at least a partial fill of your position in case the price doesn’t violate support.

Any of these methods might enable you to place stops below obvious levels, after the market push has passed through them. That reduces the chance that stops will be hit because of a short-term, artificially created outlier move in price.

Ultimately, you can't stop high-frequency traders from executing their trades and making a penny a zillion times, but as an investor you're simply trying to protect your position. 

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