introducing ... stops ... embracing ... stops

I've been avoiding an issue, but I don't think I can avoid it any longer. That issue is stops. The system I've been using is buying when the price looks right, and then hoping for the best. It should work, but ... well, here's how that system works: seeing an opportunity, you place an order to buy at a price you like. If your order is filled, you then wait ... for the stock to go up ... to a target. When the target is achieved, or there's some other reason to sell, you sell, or try to.

Quite often, after I've bought a stock this way, it has gone down. I could no longer sell the stock for anything near what I paid for it, so I just had to wait - either that or take a large loss.

In attempt to reduce risk, I've been entering many such trades, each with a small or smallish investment. Many of my bets have been $100 investments. If I sold when they were down 50%, I would loose $50 on one of those ... as an example. I've also placed some larger bets, trying to select safer positions. Then it gets kind of scary - although, knock on wood, the larger bets have been behaving OK ... not great, but OK.

Here's how investing with stops might work: Seeing something in the chart, you place an order to buy at a certain price. The order price is essentially marked in the chart. Then, if your order is filled, you immediately place a stop loss order, at another price, which is also marked in the chart when you place your buy order. If prices then fall, your stop loss is triggered, and you sell for a loss, but a small loss. If your stop loss isn't reached by falling prices, you can ride prices up to your target, or selling trigger.

Well, we need to test this. If you take enough small losses, they will add up to a losing system, but if you can succeed a high enough percentage of the time, you can claim to have found one of the holy grails, rapid and substantial gains, with limited risk. What can we learn by looking at examples in market history?

Here's a randomly selected chart, with which to begin:

It's a random selection, but it is an actively traded stock.

The essential buy signal in classical technical analysis, or chart reading, is the head and shoulders breakout. An example can be seen in April on this chart. The head is the two bar bottom in the middle of the month. The left shoulder is kind of a two bar shelf at slightly higher prices, and the right shoulder is a three bar shelf at the same level as the left shoulder. Then, prices break out above the two shoulders.

The prescribed action upon seeing a breakout of that sort is an order to buy at the high price of the right shoulder. The logical place for the stop is just below low price of the right shoulder.

Your order would have been filled a day after you placed it, and you would have been stopped out after another five days, so the whole trade would have lasted 7 days, plus a weekend, and then you would have and know the result: a ten cent loss, which would have been about 5%. There's also a loss associated with commissions. If a trade costs $7.50 - approximately the going rate for any size trade - on a $100 investment, that's an additional 15% loss. On a one thousand dollar investment, it's an additional 1.5% loss. In the case of a successful trade that is not stopped out, it's a reduction in the gain, but the major concern here is, you really don't want to loose 15% on top of the loss associated with being stopped out, so trading with stops requires you to place larger bets. But it also protects those bets, at least theoretically, so it at once requires you to and allows you to place larger bets. And larger bets have other advantages, so, assuming it works, trading with stops sounds like a good thing.