A line in the sand

Trading with stops is probably the most important risk management technique one can employ as a DIY investor. Most advisors (use the 80:20 rule on this one) will not use stops and typically only use buy and hold as a strategy (don’t get us started on that one as it is a core fundamental flaw in the investment industry, which is set up to generate fees for fund managers at the expense of risk management for the investor). When establishing a zone to cut risk, consider the following thoughts:

1. Establish a level where pattern of higher highs and lows is broken
2. Key reversal days or major trendlines
3. High volume/breadth thrust/breakout days

The level of risk one can assume as an individual is always key here. For example, someone who has held a long position through last summer’s decline and recovery and through most of 2008 and 2009 should not be taken out by a reaction to the debt ceiling FUBAR.

There is a clear support line that has been established from the 2009 and 2010 lows, which would be violated if the June lows were taken out. From last week’s close, that is about a 7% decline, which from the perspective of the recovery is rather minor. But if you put all your money to work last week after kicking yourself for the past 2 years and finally had the courage to jump back in, you would not want to take that much risk.

Last week’s low of 1295 would provide a better LITS or even a close below the low (1325.65) of the higher volume advance seen last Thursday. Last Thursday has all three classifications and would make good point to cut risk for traders. In the educational segment video above, have a look at how the S&P 500 bounced around last summer seemingly clearing out stops for both the bulls and the bears before finally reacting bullishly to the Fed’s QE2 promise.

Those hoping for QE3 will be disappointed any time soon, we need to see the unemployment rate jump back towards 10% and or the GDP forecast to turn materially lower than it is.