DHI and stop losses

Hey Five Star Trader,

A Tuesday Trade Edition: One of the most important concepts in trading is to review your work, and learn from the good and the bad. It’s critical to identify what’s working — to do more of it. Each week, you’ll get a trade from my trading journal, in which I explain my whole thought process from start to finish. Trading is all about finding something that works, and applying it, over and over again. That’s how you find trading success. So study up on this “Tuesday Trade” and let’s get to work.

Last week, the market was rocked with some big moves to the downside and many traders may have lost more money than expected. That’s why, for this Tuesday trade example, I want to show one of my losing trades, and specifically talk about setting stops so we can learn what we did wrong, and how not to do it again.

When do I set stops?
Knowing when to put a stop loss on a trade is a very important skill for a trader to have, but how do you know when is an appropriate time to one? For me, it all boils down to how big of a trade I’m taking. If my trade is larger than an average position, I will use a 50% stop. Typically, this would equate to about  4%-5% of my entire portfolio. The reason I do this is because, at such a large ratio of my account, I don’t want to risk taking on a max loss. An example of this could be me buying a debit for $5 and then closing it out if it got to about $2.50. Setting this stop like this means I can take on the risk without fearing I’m going to wipe out my account.

If the overall position I’m taking is 3% or less of my portfolio, my rule of thumb is not to set a stop at all. Though you are risking losing the max amount possible here, you are also able to sit through volatility and see if you can catch a big move. For me being a momentum trader, 3% or less is risk is worth the massive potential for gains.

Let’s break down how I incorrectly stopped out in DHI… 

As I mentioned earlier, the market had a tough time last week and we all felt the repercussions of it. The NASDAQ was getting increasingly volatile and had broken down below the 50 period simple. It had a brief recovery six days later but ultimately began trending downward again. Fearing that this could be setting up for a margin call Monday or a market crash, I decided I wanted to lighten my positions, including DHI.

I originally got into DHI with a large position because I really liked its daily squeeze, it was a Phoenix stock, and the macro condition was supporting the fact that people are buying homes. Unfortunately, as soon as I got in, the NASDAQ went right into 10% correction territory. Following my rules about position size and stops, I decided to take a 50% stop.

Now, you could say, well, Danielle followed your training plan, and that would be true. But in this instance, that was the wrong call to make. Three days after taking my loss, the market bounced and I lost out on potential profits.

Lessons learned…

In hindsight, I wish I had decided to take on a smaller position of DHI, which would have given me the confidence to ride the wave instead of stopping out for a loss. But the reason I’m writing this newsletter is because I think it’s important to talk through different ways to manage trades. If you are not willing to take a max loss, always set a stop, but remember it’s an option to take on a smaller trade- this will allow you to sit through volatility and you may end up making more profits in the end!

Going forward in these market conditions, I’m going to take this lesson and cut down my position size on each trade as well as on my overall account. Let me know what parameters you use for your stops in the comments below, and careful be careful trading out there!