New weekly high, and a word on stops

08/05/2010 by Philinje.

It happened. Gold closed at a new weekly high, its highest ever. With a relatively neutral NFP release and equity markets figuring out the mood is quickly getting bearish, gold bumped into $1210 again and closed at $1207.

Considering the lengthy consolidation of the past 4+ months and the relatively gradual climb to above $1200, it looks likely that gold will see some more upside. The near-term projection of $1350-ish seems healthier than ever. Of course that is no guarantee - there are no guarantees in the markets.

Interestingly, silver caught up in a big way on Friday. Some folks must have decided its monetary aspects were a bigger factor than its commodity nature, which had been holding silver back earlier in the week. As the problems in Euroland seem to sink into the market’s psyche, monetary safe havens are the name of the game.

Speaking of which, gold in Euros was turning parabolic this past week. It eased off a bit on Friday as the Euro stabilized, but basically Euro gold was looking like a hockey stick curve getting to a peak. If the Euro bounces, a good buying opportunity might present itself. And yes, the performance of gold in Euros is a nice supportive indicator - precursor, if you will - of what could happen to gold in dollars.

Looking at the ugly situation in equities, it may behoove us to discuss stops. An absolutely essential element of any speculative trading includes stops, and when it comes to anything in equities these days, stops are now essential. This is NOT a buy-and-hold market. Anyone still with the mindset that parking a bunch of retirement savings in GE or Intel with no stops and a timeframe of 10 years is playing with fire. Many of us got burned in late 08, early 09 - don’t let that happen again.

Absolutely the worst mentality to have is the conviction that the market will come back to eliminate losses and then you can safely get out. That is the highest risk strategy possible in the current scenario, and a bad one in general. Do not get suckered by your own psychology.

As prices move up, move your stops up. That’s called a trailing stop. When the price plunges through your stop, you are out, end of story. In terms of where to place stops exactly, that involves some familiarity with the particular stock and its volatility, but as a general rule of thumb, normal equities should have a 25% stop (25% below the current price or just beneath a recent support level), and highly volatile instruments like gold could use a wider margin of safety. Some junior gold stocks, for example, might require a 50% stop. But think about it, that means you are willing to lose 50% of the value. Are you, really?

Another rule of thumb is to move the stop above your entry as soon as possible, meaning after the price has moved about 25% above your entry price. That way you will not lose money. Every day that your stop remains below your entry, you are at risk of losing money. Without any stop, you could lose all of it.

So the trap many people fall into is getting into a bad loss, then holding until the position comes back to breakeven. That is the worst possible way to trade anything. Instead, a stop should have triggered a small loss and then if it makes sense, a new lower entry could be initiated.

But assuming you have one of these bad losses still limping along, what do you do now? Step 1: Put a stop underneath the current price. Step 2: Move the stop up as the price moves up. Ok, maybe that particular stock has a support level 40% below the current price, such as an all-time low. Then set the stop just under that. You have to know enough about the stock to be intelligent about where to place the stop. If you dont know enough, why are you in that stock at all? Get rid of it, ferchrissakes!

The point is, your entry is not that relevant after you’ve initiated a position. It’s only relevant to your ego. The market will do what the market will do. A trailing stop will get you out automatically, with no emotion or ego attached.

Having said all that, using stops with gold or silver is extremely difficult. The best approach is to get the best possible entry and keep a stop well below a recent support level until the price moves up significantly to a new area. But the price swings can be large so stops may get triggered. As a rule of thumb, the less confdent you are about a position or entry level, or the bigger the gain gets, the closer the stop should be. That’s the inverse of what you would think intuitively.

Think about it. Let’s say a month ago you bought some GLD at just under $1100, knowing that was a major support level. Then a stop at $1040 or so might make sense, because that would be a key area that indicated a major breakdown was occurring. Your loss would be large, but not as large as it could be. Then, when the price broke through $1160, a major resistance area, you move the stop up to $1090. I know that breaks the rule about getting above your entry ASAP, but with that excellent entry and the behavior of gold, it makes sense.

On the other hand, if you initiated a position at $1130, and felt a bit queasy about it, like you were just putting your toe in the water to see if a crocodile bit it off, then keep the stop pretty close, like at $1110. That way, a major swing down would take you out with a small loss and you could get back in at a lower and better level. An entry you are not confident about usually means the price has to move rapidly in the right direction for you to get to a place of safety, and that may or may not happen. Also, as price moves in your direction it gets more and more likely to turn around, so sneaking stops up closer to the price as it gets toppy is a good way to preserve profit.

Please note that the level of stop relative to the entry is what determines the size of your position. The potential loss has to be calculated at least roughly in advance so you don’t use too much money on any single position. That’s common sense, but it’s amazing how many people don’t follow this basic technique of money management.

Ironically, the better entry with the wider stop will require a smaller position. Shouldn’t you bet more money as the entry improves? Yes, and no. Getting in at a major support level is good, but speculative, meaning the price could still move to an even lower support level or just bounce around at this level. Once price moves in the right direction, it could make sense to add more, albeit at a worse level, but it’s less speculative. Your tighter stop will compensate for a larger position.

There are variations of this approach, and to each his own. But the principles are always the same.

I wish some of the books I read about trading had given me what I just wrote here.

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