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Old 06-30-2005, 09:51 PM
Dan Mezick Dan Mezick is offline
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Join Date: Jun 2004
Location: Foxwoods area
Posts: 297
Default Re: What is going on with Sirius?!?!

Every stock position can optionally protected from catastrophic loss, by employing the Stop Loss order.

It is a conditional order based on price. For example say you hold 100 shares of SIRI and it closes today at 6.70. You can place a Stop Loss order to sell SIRI at 6.40, then if and when a trade takes place at that price or lower, the Stop Loss order becomes a Market Order and your 100 SIRI are sold at the market price, as of the time the price event takes place. You take a small loss to avoid a potential catastrophic loss.

The StopLoss order is used primarily to define risk. When you take a position and immediately enter a Stop Loss order, you define your risk. The risk is the difference between the purchase price and the Stop Loss price, minus any slippage. Slippage is defined as the difference between your specified Stop Loss price and the actual fill price for that Stop Loss order.

Experienced traders seldom trade without using a protective Stop Loss order. The Stop Loss is primarily a tool used to define risk.

Skilled traders often look for spots where the upside is great and the downside is minimal. You identify the potential upside with your method. You define the downside with a protective stop.


Example:
On 6/26/2005 you see SIRI is around 6.70. You figure the chance of the price of SIRI increasing 10% or more in the next few weeks is 75%. You have 25K in a brokerage account and you want to risk no more than 1% of that on a position in SIRI. If you are correct you have identified a 10:1 reward to risk ratio situation.

Steps

1. Figure dollar risk max: Calculate the 1% risk you are willing to take. 25K * .01 = $250 risk in dollars.

2. Define your stop price: The price where you admit the trade did not work as planned . Look at the daily range in price over the past N days, or yesterday’s low, or use some other criteria you incorporate in your method. Set the stop too tight, and you guarantee you will be stopped out due to normal price fluctuations. Set the stop too loose and you define and assume more risk. Let’s say you determine $6.40 is a price that proves the trade did not work as planned. That’s 30 cents of risk per share if you bought at $6.70.

3. Determine how many to buy: Divide .30 into $250, this gives you how many to buy: .30/$250 = 833.33. Round to 800 shares.

4. Summary: To risk 1% of your 25K account on this trade, you want to buy 800 shares @ 6.70. As soon as you fill that order, you place a Stop Loss order to sell those same 800 @ 6.40 or lower. Your risk is now defined as .30 * 800 = $240 plus any slippage plus commissions. This is roughly 1% of your 25K account. You think that price can move 10% higher soon; if correct you have set up a 1:10 risk/reward situation.

Note also that if you determine the correct place to set the stop is not $6.40 but lower, say $6.20, then in that case you have to reduce the trade size to keep the dollar risk at $250, which is roughly 1% of your account. The reader might want to try calculating the # shares to buy in this case, as an exercise.

Note that .30 per share risk/$6.70 a share is 4.47% risk on the entire trade; however the total trade value is $5360 (800 shares X $6.70 per share). By keeping the trade size small and using a stop to define risk, the overall portfolio risk is 1% for this trade, even though you are taking a 4.47% risk on this (single) position.

Risking 1% on any one trade is considered quite aggressive and 2 or 3% is considered super-aggressive. This is not a misprint.

Breakout Theory

When you trade this way you look for spots where the stop can be set very tight so the risk is low. One such spot is a new high, or a high that is higher than a multi-month high.

If you look at the chart of SIRI you will see that the price achieved on 1/31/2005 is currently a 5-month high. That price is $6.70, a price that was touched yesterday. Price has been below the level achieved on 1/31/2005 for about 5 months.

Some traders think that when price gets near a historical high, many others who bought near that price in the recent past will sell. This is where they can ‘get even’ on a 2,3,4,or 5 month losing trade.

When all those miserable people go and sell to get even, they set the stage for a breakout to new highs. After most of these sellers complete what they are doing, the new crop of buyers may then drive price up rapidly because most of the sellers are now out of the way.

In theory this can result in a breakout, a rapid move in price upwards that blows through the old high (in this case $6.70) and then moves sharply to a new, higher level of price equilibrium.

So in this case I was saying I can buy at SIRI at 6.70 in anticipation of a breakout to new highs, and I can define my risk to be very low in this spot if I decide to back my opinion with money.

I hope this explanation helps. Stops are essential to risk control. Choosing to enter in spots where stops can be set fairly tight is usually advantageous. You may enter several times and be wrong, taking a very small loss. If and when price breaks out, it pays for all the little losses "plus".

Many traders that utilize a breakout method may enter and exit fearlessly on tight stops several times (aka experiencing “whipsaws”) before entering at the place where price ultimately takes off.

See also:
http://tradingalchemy.com/ReadAboutBreakout.htm
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