Friday, October 15, 2004

To trail the stop-loss, or not to trail the stop-loss?

The "Investor's Corner" column from today's IBD discusses O'Neil's stop-loss and buy-stop techniques. Here are my thoughts on this:

The column author discusses placing buy-stops at the pivot points defined in O'Neil's book HTMMIS: 10 cents above the high in the base. I can watch the market from my desk so I don't use buy stops, but I think they are useful as long as you can trigger a stop-loss when your buy-stop hits if you can't watch the market.

However, I don't buy at O'Neil's pivot points very often anymore because this year's fickle market won't let you get away with any mistakes, and many of the stocks that set up cute little handles are wolves in sheeps clothing. It seems that overhead resistance isn't the problem in the strong stocks right now, the problem is the underlying support. Even though a stock might set up nicely within 15% of its 52-week or all time high like in the book, odds are the stock has already run up significantly last year and so the people who bought back then are selling their shares to the newcomers who have to deal with shorter rallies and longer declines in the market averages. If you look at the 2-year chart of the nasdaq, you will see that there were just as many, if not more declines in 2003 as in 2004, but they were smaller in magnitude and didn't last as long. In 2003, time was on the side of the shareholder. Not so in 2004.

This brings me to my second criticism of the column that applies when you are trying to make O'Neil's system work in this sideways market: not trailing your stops. I keep a stop-loss on every stock that I buy or short and advance the stop every day no matter what my stock does. Think about what this does! If you buy into strength, then time is on your side! Your advancing stop will automatically kick you out of the stock when it starts to show weakness. You are only vulnerable during the first few days after your purchase except in the rare cases where a stock gaps down from an up-trend instead of trades down.

I'm not going to discuss exactly how I place my stops each day, because everyone should have their own system for this that they are comfortable with. Buy on strength, maintain your stops, and let them take you out of the stock. By doing this, you don't need to wait for handles or pivot points, you only need to see a new show of strength and give the stock enough room to account for its normal volatility during its run.

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