Dear Reader,

“What do you mean I’m already stopped out?”

This is, far and away, the biggest question we’re getting since we released Smart Trailing Stops 2.0 (STS 2.0). I understand the question.

I know that STS 2.0 is different than what long-term-trailing-stops users are accustomed with. It’s really different to use an automatically-detected high price from the past rather than using your entry date and entry price as the initial point from which to trail the stop. It leads to all sorts of new questions.

I also think that it’s a huge advance and I’m going to show you why I set it up this way, and share some suggestions about how to deal with stocks that are “stopped out” sooner than you’re used to.

But first, let me show you what I’m talking about.

Following the launch of our new STS 2.0 algorithm, we added a simple interface to easily convert STS 1.0 stops to the updated STS 2.0 algorithm. Here’s a sample from a TradeStops account:

STS1-2-updated
In the case of WMT here, the STS 1.0 alert had a Current Stop Price of $76.89 while the STS 2.0 alert had a New STS Price of $79.84. The Latest Close on WMT as of this writing was $77.88. So the STS 2.0 alert is stopped out but the STS 1.0 alert is not yet stopped out.

Here’s how it looks on a chart of WMT:

WMT
Even though both the STS 1.0 and the STS 2.0 use the same percentage stop of 11.2%, the STS 2.0 alert is stopped out while the STS 1.0 alert is not yet stopped out. How come?

The difference is that the STS 2.0 alert is trailing the stop from the automatically-detected high close of $89.93, whereas the STS 1.0 alert was trailing the stop from a more recent high of $85.52.

Clear so far?

Let me share with you an even more dramatic example.

In the video available on TradeStops.com in which I introduce STS 2.0, I share this chart of GDXJ, the ETF of junior gold miners:

about trailing stops
The above chart shows how GDXJ made a significant high of $45.19 in July of 2014. At the time, the Volatility Quotient, or VQ, on GDXJ was 39%. GDXJ corrected more than 39% from its July 2014 high and was stopped out in late October 2014.

Here’s the thing… if you go to put a Smart Trailing Stop on GDXJ today, you’ll get the message that GDXJ is Stopped Out.

Huh? How could a stock be stopped out when you don’t even own it? What exactly does that mean? Does it mean that you shouldn’t buy the stock?

First of all, if a stock is showing as Stopped Out per STS 2.0, it literally means that the stock has already corrected by more than it was expected to correct in the normal course of business. It means that it has moved further than VQ% from the recent high close as detected by the STS 2.0 algorithm.

In the case of GDXJ, the stock moved down more than 39% from its significant high of $45.19. The Smart Trailing Stop price on GDXJ was $27.57. GDXJ was stopped out when it closed below $27.57 on October 30, 2014. Moreover, with STS 2.0, once a stock is stopped out it stays stopped out until it proves itself again by triggering a new Re-Entry Rule.

I know that this is a bit different than what many of us are used to when we think about trailing stops but I did it this way on purpose. I did it this way because I believe that it delivers the best value to TradeStops subscribers. I did it this way because my research showed that this method delivers the best results.

Smart Trailing Stops have always been based upon the concept of the normal expected volatility range for a stock – what we now call the Volatility Quotient or VQ of the stock. Smart Trailing Stops 2.0 introduced the additional benefit of automatically identifying the best high closing price from which to trail the stop.

That’s why, like we saw with GDXJ, a stock can sometimes already be stopped out by the STS 2.0 algorithm, even if you’ve just bought the stock.

Now then, just because a stock has a current STS 2.0 status of Stopped Out does that mean you shouldn’t ever buy it? No, that’s not what it means. A STS 2.0 status of Stopped Out is just telling you that the stock has already corrected more than what would normally be expected of the stock.

This is valuable information! If you have a good reason for buying or holding the stock, then by all means, please do so. But the fact that the STS 2.0 algorithm has stopped out of this stock is information that you should definitely consider.

You should consider it a big red flag on the stock. The stock is not behaving normally. It has recently suffered a relatively severe correction. Dogs that bite once often bite again.

Believe me, I know how tempting it is to look at a stock like GDXJ and say, “It’s already down 40% since July 2014… How much lower could it go? I’m going to buy it now while it’s cheap.”

I’ve done it myself… more times than I care to admit!

Let me show you something that I think you might find a bit shocking. I’d like to show you how many times GDXJ has fallen 40% since April of 2011.

In April 2011, GDXJ made a high of $150.04. Just 8 months later, in December 2011, GDXJ had fallen 40% to $88.34. Was it now a bargain?

Well, it did rally briefly but by April of 2013, GDXJ had completed another 40% fall from $88.34 to $53.04 by April 15, 2013.

Surely, now GDXJ was a bargain, right?

Well, by December 2014, GDXJ had completed yet another 40% correction when it closed at $21.31.

Here’s how all that looks on a chart.

GDXJ_6yr
Each shaded area represents a drop of 40% from the price at the beginning of the shaded area to the price at the end of the shaded area.

I’m sure that some of you by now are really itching to buy GDXJ after it’s fallen so far. I know because I can feel it tugging at me!

Do you think that it’s unlikely that GDXJ will fall yet another 40%? I wouldn’t be so sure. A 40% correction from $21.31 is only down to $12.79. That’s less than $9 from where we are today!

Now again, all of this isn’t to say that you shouldn’t buy GDXJ. It’s just a huge red flag – exactly the kind of red flag that Smart Trailing Stops 2.0 was designed to bring to our attention.

So, assuming that you have decided to buy GDXJ, how can you best manage your risk in GDXJ since the Smart Trailing Stop on it is currently Stopped Out?

You’ve got a few options:

  1. Don’t buy the stock yet or sell it if you already own it. My best algorithm is telling you that this stock has a severe storm warning on it. If you’ve got a good reason to still buy or hold onto the stock, then please proceed, but proceed with caution.
  2. If you’re following a newsletter recommendation, then use the recommended strategy of your newsletter editor.
  3. Use a simple percentage trailing stop of your choice –25%, 35%, 45%–whatever you want.
  4. Check the current VQ% on GDXJ and use a trailing stop at that level. The current VQ% on GDXJ is 41.6%. So you could set a simple trailing stop of 41.6%.
  5. Control your risk by limiting your position size. You could even go as far as not using any stop loss at all as long as you only put as much money into GDXJ as you’re willing to lose completely!
  6. Limit your risk with options. For example, you could strictly limit your risk by buying some call options on GDXJ. You could buy the November 2015 $30 call options currently for $1.75. That means that for $175 you have the right to buy 100 shares of GDXJ at $30. If GDXJ soars 100% from here in the next 6 months, then those call options will be worth nearly $2,000. If GDXJ goes nowhere or falls even further, you’re only out $175.

My personal strategy on GDXJ would be to wait for the Re-Entry Rule to trigger and then look for an entry point on a pull back into the Low Risk Buy Zone. (These features will be available in TradeStops Pro by the end of May.)

I’m not giving you all these choices to overwhelm you. I just want you to really understand two things:

  1. The Smart Trailing Stop on GDXJ is currently “stopped out” and this is a red flag on the stock. It is telling you that the stock has already corrected more than should have been expected of normal corrections. If you’re going to stay in or get into the stock, be cautious.
  2. There are lots of other ways that you can still buy GDXJ and intelligently manage risk even though the Smart Trailing Stop is currently stopped out.

I know that a lot of you look to TradeStops to just “do it for me.” I know that STS 2.0 is a little different than the way that we’ve done things before.

I do want you to understand that a Stopped-Out status of my STS 2.0 algorithm is an important piece of information that I want you to be aware of. I also want you to know that I am working on several ways for you to easily and automatically apply a default alternative strategy to those stocks where the STS 2.0 is currently stopped out.

That’s all for now.

To the growth of your wealth,

Richard M. Smith, PhD
Founder, Tradestops.com
CEO, TradeSmith