Profit From Prices

A book on stock market trading
By Jayesh Patel, CFA

Chapter 4

STOP-LOSS: HOW TO USE IT IN TRADING

PROGRESSIVE STOP-LOSS

Stop-loss is mostly referred to a loss situation. This should not be the case. Stop-loss can also be used to a trader's advantage in a profitable trade when prices are moving the direction he wanted them to. A Protective Stop-loss level can be changed in the direction of the stock price. If one has taken a long position and the prices are going up, he can increase his stop-loss level. This makes it a Progressive Stop-loss. (The word "Stop-loss" word becomes deceptive in this context. Instead of relating to a loss, it is used to protect a profit).

Let me explain a Progressive Stop-loss in more details. Let us continue our example above. Assume that the trader bought the stock at 50$ after a Minor Bottom was confirmed at 45$, and kept a stop-loss with 5% distance which is 42.75$. This is the initial Protective Stop-loss.

Assume that the stock price goes up and touches 55$ and then enters into a reaction and slides back to 50$. The day it touches 50$, the high was 52$. Now again the price seems to be going up and there were three consecutive days on which stock traded above 52$. This will confirm a higher Minor Bottom at 50$! Now he can raise Stop-loss to 47.5$ (50$ minus 5%) from initial level or 42.75%.

Assume that the stock resumes it up-trend and makes a higher Top at 65$. Then it slides back to as low as 58$ and passes the 3-day test of a Minor Bottom. So now one can raise his Stop-loss to 55$ (58$ minus 5%). This trading position is in profit now and profit is also sort of guaranteed! Say the upward trend in prices of this stock continues. It touches a price as high as 85$. Subsequently let us say a Minor Bottom is confirmed as per our three consecutive days test at 78$. So the new Stop-loss level is now at 74$ (78 minus 5%).

Now let us assume that after the last Top and Bottom being confirmed at 85$ and 78$ respectively, the stock fails to go higher than 85$. This is an indication of some weakness. Now when it starts going below 78$ (the last Minor Bottom), one should get worried. Still there is no need to sell the position because the stop-loss is 5% below the last Minor Bottom. This helps us if the stock is forming a mid-trend pattern like flag or pennant. If after going as low as 75$, the stock resumes its upward trend and goes above 85$, one is still in the game! However if it does not go higher and instead goes below 74$ (current Stop-loss level), one should close the position. As you can see, even if the stop-loss triggered, the position had a profit of 24$ (Sell price 74$ versus purchase price of 50$) per share!

I hope above description about Progressive Stop-loss makes sense to you. Here is one real example:

This is the Chart of BRCM (Broadcom Corp)- a one-way superstar, during 2002. Around that time, I was watching it closely. It was drifting from 40$ down to less than 20$ but did not confirm any Minor Bottom on the way according to the 3-consecutive-days test. Ultimately it touched 18.40 and then later on, on 3rd, 4th and 5th day it passed the 3-day consecutive rule! It formed a Minor Bottom as marked on the Chart. It was a buy signal for the first time and one could have bought it for around 25$. Initial Protective Stop-loss would be at 16.50$ (18.40$ minus 10%) allowing a loss potential of 8.50$/share!

The next Bottom -- Bottom2 -- was confirmed at 27.50$ which would bring the Stop-loss to 25.00$ (27.50$ - 10$). Then it made another higher Minor Bottom -- Bottom3 -- around 33.00$ bringing the Stop-loss to 30.00$. At the time, the Chart was drawn, BRCM stood at 45$. At that time, one could have booked profit of 20.00$ or like an astute trader, he could have held on to it with a 30.00$ Stop-loss and raising it progressively higher if the stock continued to confirm new higher Bottoms.

 

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