Monday, September 7, 2009

Schabacker on stops

If you haven’t read Richard W. Schabacker’s Technical Analysis and Stock Market Profits: A Course in Forecasting, originally published in 1932 and subsequently republished, most recently by Harriman House in 2005, you have missed an important seminal work. Schabacker expanded on the work of Dow theorists and, by focusing on individual stocks rather than the averages, he discovered new tradable patterns. His brother-in-law was Robert D. Edwards of Edwards and Magee fame (Technical Analysis of Stock Trends); they further analyzed, systematized, and expanded his work.

In today’s post I’m going to focus on one short section of Schabacker’s book: stop-loss orders. I won’t repeat the obvious advice about the wisdom of stops (obvious, that is, except to those who don’t believe in using stops—and, yes, I’m quite aware of systems that are profitable only because they don’t incorporate stops). The question is where to place stops. “While,” Schabacker writes, “we may grant readily that any formula—even a rigid arithmetic rule—is better than none,” ideally there should be some defensible rationale for the placement of stops. “Stops are used to relieve us quickly and automatically of ‘bad trades’ if the forecasts upon which we based those commitments turn out to be mistaken, or if there is an unexpected change in trend. They should be placed, therefore, so that they will be caught by any price movement which reverses our original forecast or indicates that a trend which has been working in our favor now has turned against us. At the same time they should be so placed that they will not be ‘touched off’ by any minor movement which does not upset or reverse our basic forecast.” (pp. 365-66)

Schabacker studies the case of a long position in US Rubber, initiated on a breakout on increased volume over a symmetrical triangle. There were two potentially negative scenarios: first, that price would drop back into the pattern but would then trend up and, second, that there might be a sharp shakeout. It’s the second case that Schabacker wants to protect against. Here he advocates an allowance of x% of the price of the stock at its previous minor reversal low, where x is dependent on the volatility of the stock. With US Rubber he opted for a 5% initial stop. He bought the stock at market on September 24 (presumably somewhere around 33) with a stop at 28.5, 5% below the previous minor pullback to 30. The next day the price dropped back into the pattern slightly to 31.5 but then decisively turned up again, with the 28.5 stop unexecuted.

After prices move away from a good forecasting pattern there will be minor pullbacks, gaps, continuation patterns, and congestion, all of which establish new minor support points that provide a basis for new stop orders. Now assuming that the trade starts to move in the predicted direction and then suffers a minor pullback, how soon is it safe to move the initial stop? “Our rule is to wait until the price ranges of two days are entirely beyond the price range of the day that establishes the new stop-loss level. If we are working in an up-trend . . . we wait until the low prices on two days are higher than the highest price during the bottom day of the dip.” (p. 368)

On October 3 there was a continuation gap from 35.5 to 36. “Continuation Gaps, as we know, set up minor support and resistance levels which are not as a rule broken decisively except by a change in trend.” (p. 369) So, applying the “two days away” rule, the trader should wait until two days range entirely above the high of the gap; in this case it occurred on October 8.

Of course, one never moves a trailing stop except in the direction of profit. So when price moved down to 34, only 0.25 point away from the stop, the stop was kept, not shifted down. And on and on the trade went until it was finally stopped out.

Schabacker cautions against using stops when trading within patterns. “Trading within these areas . . . is precarious at best and, unfortunately, the use of stop orders does not make it any safer since they can seldom be placed close enough to turn the odds in favor of the profit side without undue risk of loss.” (p. 374)

And finally, Schabacker does not advocate simply waiting to be stopped out. “In the great majority of trades the student will, if he follows his charts closely, see some sign of reversal or exhaustion which will enable him to take his profit and get out at a much better level than his current stop orders.” (p. 375)

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