Managing Risk in a Rallying Market
When the market is rallying everyday and seemingly every long position can be held without worry, it is easy to fall into bad risk management habits.
The Dow has rallied for 8 straight sessions now but that doesn’t mean you can afford to stop thinking about how you are protecting your positions.
With that in mind, I want to spell out for you some of the most common mistakes that traders make when the market is moving higher everyday.
You’ll want to pay close attention here, these tips might end up saving you a ton of money in the future.
Mistake #1: Using the Same Stop for Every Position
You’ll hear a lot of traders talk about risk management in very absolute terms.
“I always use a 2% stop loss regardless of the position.”
While I think that this is definitely a better approach than not using stops at all, it isn’t much better.
When I am considering where to place a stop loss, I shouldn’t be using an arbitrary number for every single one of my positions. I should be taking into account support and resistance levels, upcoming catalyst events, and other technical indicators when choosing a level.
These levels are much more likely to be relevant to the specific position and therefore should hold up better in practice.
Mistake #2: Putting Stops Right on Levels Of Support Or Resistance
As mentioned above, a trader should be using technical support and resistance levels for setting stops.
However, many traders who do this in practice make one key error…
They put the stop loss order right on the support or resistance level. To clarify, let’s look at a quick example.
I am long stock XYZ at $100 and see significant support at $95. If this support is broken, I want to exit the trade. In this scenario I would NOT want to put the stop loss order right at $95.
I would pick a level below $95 as this will make my stop “safer.” If $95 is a clear level of support it might be a target for institutional or high frequency traders
Oftentimes we’ll see markets slam to support levels, in an attempt to shake out weak hands, and then rally right back. Don’t let this happen to you.
Protect your stops a little more by putting them just below these support levels.
Mistake #3: Relying on Stops Ahead of Catalyst Events
Catalyst movement and regular trading are two very different things. If the market is moving higher everyday it really doesn’t mean anything for a catalyst position.
It can be easy to forget this.
Think about the scenario below…
Stock XYZ is trading $100 and reports earnings tonight after the close.
I am long with a stop loss order at $95.
The earnings are released well below consensus estimates, a huge miss for stock XYZ. On the open the following day, the first trade in XYZ crosses the tape at $89.
I am stopped out of my trade at $89, the market isn’t even close to my $95 expected exit level.
This is what’s known as an opening “gap.”
When gaps happen they can completely destroy your stop loss levels. Because equity markets don’t trade all night this is always a risk and should be the first thing on a traders mind ahead of earnings or other catalyst events.
Don’t Let a Strong Market Fool You
These are only 3 of the most common stop loss mistakes traders make. While this is not an all-inclusive list these 3 should definitely be at the front of your mind when setting stop losses.
Risk management will always be the most important thing you as an investor. Don’t let a strong market lull you to sleep on this, trust me.
Regards,