Stops Part 2 – When To Use Them

It’s been a couple of weeks since I wrote “Stops – When Not to Use Them”. In that post I suggested that using stops when trading mean-reversion systems hurts performance in the long run. There were many good comments left after that post which I will address in the next post on this subject. Today, though, I’m long overdue to tell you when I think stops ARE appropriate.

While stops do not work well for overbought/oversold trading, they DO work well with breakouts or trend following systems. Traders that buy on a pattern breakout do so because their analysis indicates a trend could emerge in the stock or security they are trading. A reversal back into the base or below it would invalidate the pattern from a technician’s standpoint. Therefore in such cases I believe a stop is completely appropriate. Once the pattern “fails” you should no longer be in the trade. Of course some people may want to give a little extra leeway rather than putting a stop right at a support point, but even so, there is a point where the breakout simply didn’t take.

For my own breakout trading I tend to use very tight stops. I also tend to show little patience for a trade to work once I enter it. Most successful breakouts have a tendency to work right away, and when the market environment is conducive to breakouts there’s just no point in sitting around with dead wood. I’d rather exit with a small profit or loss and try the next one.

The edge in breakout or trend trading is not in the winning percentage. It’s in the risk/reward. A big winner can gain several hundred percent if it goes on a tear. That makes up for an awful lot of scratches and small losses. As an example in 2003 I did a lot of breakout trading. Cup & Handles, Flat Bases, High Tight Flags, Double Bottoms, etc. – all based primarily on daily bars. It was a tremendous year for trading breakouts because the ones that took caught fire rather quickly. It was also one of my best market years. Yet at the end of the year I went back and tallied the percentage of breakout trades I took that “worked”. In other words, they did better than a very small gain or scratch. My success rate? A little under 15%. And it was a great year. Why? Tiny losses and massive gains.

Everyone’s style is different and someone with more patience would likely have had a better win rate, but the win rate wasn’t important. What was important was controlling the losses, and one way to do that was through the use of stops.

For more discussion on using stops check out some older posts from:

Afraid To Trade

IBD Index

Also, for some (much) older discussion on trailing stops you can check out my “Double Support Trailing Stop” concept.

To be continued…

The Importance Of Positioning In Analysis

So what typically occurs after strong selloffs like we saw Tuesday? When considering the potential influence an individual bar may have on future bars it is important to consider the positioning of the bar we are studying. A sharp selloff coming when the market is extended up has a whole different meaning than a sharp selloff when the market is extended down. Let’s first look at the current situation to see what I’m talking about.

Here we see the sharp 1-day selloff has typically led to a muted bounce that then rolls over to make new lows. Instances are a little low. When I loosened them to a 2% drop I saw the same pattern.

But what if the market was at a 5-day low instead of a 5-day high? Results in that case would be much different:


Here we see a sharp initial bounce that is followed by more upside. In this case the sharp selloff is possibly exhaustive. That’s not the case when coming off a top. The expectation turns from negative to positive based on where the sharp selloff is occurring. So remember, when considering the meaning of a bar or pattern or of bars it is also important to consider the positioning.

Overbought Nasdaq With Low Spxy Reading Suggests Downside

We’ve seen numerous times how low Spyx readings typically lead to weakness or at least underperformance over the next few days. Both the S&P and the Nasdaq posted low readings on Monday. I decided to look at the situations where an extremely low reading came in an extremely overbought market as we’re seeing currently with the Nasdaq. This first test uses a Spyx level of 20 or below:

(click to enlarge)

A short-term bearish edge is apparent based on the above. Not shown but also notable is that 85% of all instances closed lower than the close of the trigger day at some point in the next 3 sessions.

The actual Nasdaq Spyx reading Monday was about 5. Lowering the Spyx requirement from 20 to 10 produced the following results:
(click to enlarge)

Instances here are a bit low but it appears the edge is even more pronounced with the extremely low Spyx reading.

A chart with the current S&P 500 Spyx reading is updated on the home page each night.

Some Thoughts On Bear-Only Edges

One study I looked at this weekend was how the market reacted following times when the SPY gapped higher, never traded down to the previous day’s close, and closed above its open as it did on Friday. Friday was a bit of a borderline example since the gap was small and it came within 1 cent of filling the overnight gap, but the results were interesting nonetheless. Rather than use a results table as I normally do I decided to show an equity curve of this study. The equity curve assumes a 5-day exit. It may be a bit difficult to read the dates below. The test was run from the SPY inception in 1993 though 2/6/09.

What I see is an incredibly strong and consistent tendency to reverse and trade lower has been evident since the bear market began in late 2007. This tendency did not exist prior to that. It is worth taking note of such test results for a couple of reasons: 1) To understand how the market is reacting to such setups currently (or in the recent past). By knowing what the market current tendency is you can position yourself to take advantage of it. 2) To consider possible implications if these kind of setups stop preceding strong negative market reactions. The bear market reaction has been extremely negative. If negative reactions to this or other similar bear-only studies stop occurring it could signal a shift in market dynamics and a possible rally.

Further Detail On The Recent Spyx Study

A commenter, Frank, on the recent Spyx study questioned how the setup has worked more recently as opposed to over the entire period from 1995-present.

Below is a short excerpt from Tuesday night’s Subscriber Letter which addresses Frank’s concern and provides more detail on the setup. It’s fairly common that I include additional information on studies in the Subscriber Letter, and this was one of those instances. As a refresher, the setup involved a 1.25% rise in the S&P 500 and a close below 25 for the Quantifiable Edges Spyx reading.

This setup has been especially bearish during the current bear market. Below are all instances since October 2007 along with their 4-day returns:

Ten for ten to the downside in this case.

Subscriber Letter Trade Results For January

Like December, January was a bit slow for trade ideas. A big reason for this was that there were no Catapult trade ideas that filled. There were several that triggered on 1/20 but the gap up on 1/21 kept them from receiving fills.

I only tracked 2 “system” trades in the Subscriber Letter during January. Subscribers that may trade more aggressively than me can find additional setups almost every night in S&P 500 stocks as well as ETF’s by checking the “System Triggers” page in the members section of the website.

The “Index” trades are typically SPY and QQQQ trades based on the short-term market outlook section of the Letter. The outlook is based on edges identified in my market studies. One tool I use to quantify the different studies is the Aggregator.

Now for the usual caveats and explanations before unveiling the results.

I don’t suggest position sizes. The primary reason for this is I’m not acting as a financial advisor. I don’t feel it is appropriate to suggest allocation sizes without understanding someone’s financial situation and risk tolerance. Even for my own trading I run different portfolios with different levels of aggressiveness. For instance, my most aggressive portfolio is my IRA. Here I may use options to sometimes get 400-500% leveraged. Other portfolios on the other hand normally take much more conservative stances and some rarely reach or exceed 100% exposure.


Since I don’t suggest position sizes this is should not be considered a performance report, but rather a trade idea scorecard. Therefore, no matter how objective I try to be the reporting of the results is always going to be skewed depending on how you approach the trades. For instance, I always recommend scaling into the Catapult positions in 3 parts, whereas the “System” trades (whatever system I unveil other than Catapult) are normally one entry. The “Index” trades I normally recommend scaling into as well. For my own trading I trade much larger size with the index trades than any of the individuals. I also control my exposure by limiting the total amount invested per day. As I mentioned, this will vary depending on the account I’m trading. My most aggressive account I may put in up to 100%/day and get heavily leveraged using options. A more conservative account may max out at 15%-20% per day.

It’s unlikely anyone would have taken all of the trades with equal amounts, so personal results would vary greatly depending on the trader’s approach. All that aside, below are January’s results (click to enlarge):

If you’d like to try out a Quantifiable Edges subscription then click here for a free 1-week trial. (Only a name and email address are required.) For complete subscription information to the Gold package click here.

January Barometer

The January barometer is a well known study that is often referred to. It states that “as goes January, so goes the year”. In other words, if January closes down, there is a good chance the entire year will close down. Of course the bear case has a head start. I decided to eliminate that head start and look at performance from the end of January forward. Below performance is shown from the end of January to the end of the year. I used the Dow Jones Industrial Average from 1920 – today. Dividends are not taken into account.

(click table to enlarge)
What strikes me here is that wins and losses are almost dead even – for all 11 time frames. When considering your trading approach from now through the end of the year I wouldn’t worry too much about January’s performance.

Low Volume Spyx Reading On Strong Up Day Historically Bearish

The Quantifiable Edges Volume Spyx indicator came in at a very low 15 reading on Tuesday. In general, very low readings have been bearish while very high readings have been bullish. (For those who are new to the volume Spyx indicator, click here for the introductory post on it.) Below is a study showing returns following all instances where the S&P rose at least 1.25% and the Spyx finished below 25.

(click on table to enlarge)

Most of the bearish tendency plays out within the first 4 days. As a baseline, over the same period the average 4-day return of the S&P 500 following a 1.25% gain with a Spyx reading ABOVE 25 is almost dead even at -$0.13. This is substantially higher than the average -$840.66 decline shown in the study.

An S&P chart with the volume Spyx indicator is updated each night on the Quantifiable Edges Home Page.

2% Gaps Down Revisited

SPY is nearing a 2% gap down this morning. I performed a study back in October which looked at the tendency of the SPY to close above its gap opening at some point in the next few days after such a large gap down. Below I have updated that table with the 7 additional instances that have since occurred. The edge remains squarely bullish.

(click table to enlarge)

Unfilled Downside Gaps Coming From Overbought Conditions

The last time the market was moving off a similar overbought condition was January 7th and that day’s bar was very similar to similar to Thursday’s. It included an unfilled gap down from an overbought condition and a selloff of close to 3%. Below is a study that appeared in the January 8th Subscriber Letter that looked at similar situations. Note the study does not include the January 7th instance which led to further selling.

I also found when doing this study that the stronger selloffs led to stronger further declines on average.

When The Market Gaps Up & Continues Higher

Days that gap higher, don’t fill their gap and close above their open have a tendency to pull back over the next several days.

In order to get a decent sample size I decided to use the 1% gap level as my criteria in testing. Below I look at the daily performance numbers over the following week:


While the “% Wins” isn’t much worse than a coin toss on average, the poor W/L Ratio creates a negative expectancy. The bearish implications peak at 4 days across the sample. Not seen in the above table is that about 70% of all instances closed below their trigger price at some point in the following 3 days. This number increases to 89% when looking out 6 days.

2% Gaps Up Revisted

A few months ago I showed a table that looked at every instance of SPY gapping up 2% or more. What I saw was a strong tendency for such large gaps tp pull back and close below their gap level at some point in the next week. There have been 10 instances since and we may get another one this morning. Therefore I’ve updated the table below:

(click to enlarge)

The pullback doesn’t seem quite like the slam dunk it once did, but it still appears probable. Combined with the fact that the market has already traded higher for 3 days in a row, I’d say the chances of seeing a pullback in the next few days is pretty high.

Strong SOX Action Could Be Good For Nasdaq

I’ve discussed in the past the fact that strong SOX action can often be a good harbinger for the the market. While both the S&P 500 and the Nasdaq failed to gain even 1% on Friday, the SOX rose more than 4%. It’s especially unusual for the SOX to post such strong gains without bringing the Nasdaq composite along with it. It has provided a nicely bullish expectation for the Nasdaq going forward.

Stops Part 1 – When Not To Use Them

One topic I’ve received a good number of questions about lately is Stops. Using a stop on a position is a very popular risk management technique used by traders. My research and experience has led me to believe they are appropriate for some – but not all – types of trades. Today I will discuss when I believe they aren’t appropriate.

In Larry Connors new book, “Short-term Trading Strategies That Work” he dedicates a chapter to stops. It’s entitled, “Stops Hurt”. The chapter discusses how Larry’s research team ran hundreds of tests to try and find optimal stop levels. In doing so they came to the conclusion that for the trades they were looking at, the optimal stop was consistently none at all. In every case they found that instituting stops hurt system performance.

You should keep in mind that Larry Connors trades mean reversion strategies. Much of what I do is mean reversion based also. For instance, the Catapult system which makes up the CBI looks to buy stocks that are undergoing capitulative selling. It enters long positions in stocks or ETFs that are extremely oversold. When I first designed the system in 2005 I went through a massive series of tests to find a way to successfully incorporate stops into the methodology. Like Larry I failed to find a stop technique that would enhance the performance of the system.

I’ve gone through numerous other exercises and found the same thing time and again. When looking to trade overbought/oversold techniques, stops generally don’t work well. If the system suggests the security should bounce when it drops to $20 and it continues to $18 then it is REALLY overdue for a bounce. Any level of stop ensures you are selling an extremely oversold security that is making a low. Those are buying conditions for oversold systems – not selling conditions.

One stop technique for oversold systems that I will sometimes use that in testing hurt performance less than the other techniques I evaluated is this:

Wait until the security bounces for a bar or two. Look for a higher high, higher low, and higher close – or at least 2 of those 3. Then place a stop under the swing low that was just made. In cases like this even if the security doesn’t hit your target exit price, it still ensures that you won’t have to suffer through the entire next leg down. While it seems logical and can sometimes help avoid catastrophic trades in the long run you’re normally better off just waiting for the mean reversion to occur and exiting at your target level.

Not using stops does not equal not controlling risk. Position sizing becomes very important. Traders could also consider using options to trade their short-term positions. Options provide a natural stop (zero). I wrote a series back in the Spring (when the VIX was a lot lower) on how I sometimes use options for my short-term trading. You can find links to that series below:

Options – part 1
Options – part 2

This is getting a bit lengthy so in a future post I’ll discuss situations when I believe stops are absolutely appropriate.

20% VIX Stretch Provides Upside Edge

One index that saw a big spike Tuesday was the VIX, which rose almost 23% on the day. It closed more than 20% above its’ 10-day moving average – the first time that has happened since November 20th. Stretches this extreme in the VIX have provided a bullish historical edge over the next few days in the S&P. Below is a study exemplifying this:

Peak stats here are at 4 days. Beyond the 1st week there is no significant edge. 89% of instances saw the market close higher than the trigger price within the next 4 days. The one recent failure was early October 2008. Prior to that you’d need to go all the way back to 1998 to find another failure.