Dec 11: Can You Pass This Options Online Trading Cost Test – Most People Fail

by David Jenyns on December 11, 2005

There are two types of stops that you will use constantly as a trader, protective stops and trailing stops. When looking at your options online trading cost, generally, positions start out with protective stops to guard your investment, and move to trailing stops when the trade becomes profitable. But the best way to familiarize yourself with stops, and how to set them is to consider them being used in a trade.

Let’s say you take a long position in a stock in anticipation of its earnings announcement. It had traded at around $13 for many weeks, but last week it ran up to $16, as the first sign of its earnings run. It then slowly dropped to $14.40 over the course of two days and stabilized there for a day and a half. Today it’s started to slowly move up again, and you think it’ll keep going. You decide to buy, and put in a limit buy order at $14.8 which executes at $14.76. Since it isn’t the strongest company and the market has been flat, you decide to set a reasonably tight protective stop. You don’t want to set it too tightly, though, since the stock isn’t very volatile and the time frame for your trade is about five days. To work this tip effectively and cut your options online trading cost, it`s important to set protective stops below support levels, so you look to see where the stock has support.

There are two support levels: $13, where it traded for weeks, and $14.40, where it stabilized recently. Its resistance level is $16. If the stock moves down from where you bought it, it will almost certainly bounce at $14.40. If the stock then drops below $14.40, you would assume it isn’t ready to move up yet, and you’d be better off stopping out there and buying again later. For this reason, you also determine there’s no reason to let the stock move all the way down to $13.

Therefore, you set a protective stop at $13.75. You don’t want to set it right at $14.40, since the stock will bounce near $14.40 and then either start back up or continue down. For the same reason, you don’t set the stop above $14.40. But $13.75 seems a good place to stop, since no support level is absolute, and the stock could bounce off $14.30, or $14.50, as easily as it could bounce off $14.40. If the stock gets as low as $13.75, though, that would suggest that the stock will actually break through support. The rule is that a clear break of support is dictated by where a stock closes, not by intraday swings.

Let`s say you`ve made a good trade, and the same stock rises to $15.10, stays there for a period of time, dips sharply to $14.43, and then picks up volume and rises rapidly. It breaks through its new resistance at $15 and starts the climb to $16. The market is rallying. Now is the time to start to think about using trailing stops to protect your profit. You’re starting to accumulate a nice one. At $15.50, you’ve made 5%, and if the stock hits $16.24, your profit will be 10%. You decide that the stock should stay above its old resistance of around $15 unless something unexpected occurs. Now that the stock has broken $15, that price will serve as a new support level. Remember, old resistance becomes new support. You move your stop up to $14.85.

The stock could pull back a bit at $16, since that level served as the ceiling before. When the stock nears $16, you can choose to either take profits by selling out directly or by setting a very tight trailing stop, or by increasing the loser stop trigger to 15.30 in anticipation of further upward movement. At $16 the stock will already have moved up almost 25% from its long-time price of $13, and it may not rise through $16 so easily. You decide to set a tight stop once it hits $16 instead of selling out, just to give it a chance. So once it hits $15.70, you move your stop up to $15.20; when it hits $16, you move the stop up to $15.75.

The market’s rally intensifies after great earnings reports from three leading companies, and your stock runs up to $16.73 before it begins to fade. You quickly sell out at $16.68 for a nice 13% profit. If it had pulled back after hitting $16, you would have stopped out at $15.75 with a profit of nearly 7%. You could then have re-bought the stock if it dropped even lower and you were still convinced that it would eventually move up again.

This example demonstrates effective ways to use both protective and trailing stops that will help minimize your options online trading cost. Though each trade is unique, putting good stops in place will always perform the critical tasks of protecting your investment and reduce your options online trading cost. This locks in your profit, if you use them properly. Once you`ve mastered the art of setting stops, you will find your profits will greatly exceed your losses, and you will be well on your way to trading success.

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