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May 07, 2005

Stop Using Stops: Trading with Elliott Wave Analysis
by Robert Prechter

Bob Prechter has done a lot of thinking about how to trade successfully. One startling conclusion he's come to: traders should often avoid using stops. Here's why: If you analyze the market you're trading, you shouldn't need a stop to tell you when to get out of the trade. In fact, the point of using Elliott wave analysis is to determine where the market is in a wave count, so that you are able to see where the trend is most likely to turn. (This excerpt is taken from the March 2003 Elliott Wave Theorist, the publication Bob has been writing for more than 25 years.)

Editor's note: Today's column describes a practical application of Elliott waves for those who invest their time and energy in trading. If you would like to benefit from market forecasting based on wave analysis when you trade, please see the information about our Specialty Services at the end of this Q&A.

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Let's talk about stops.

Bob Prechter: I think people lose more money on stops than anything else. When a trader suffers five stop-outs at 10 S&Ps contracts apiece, that trader now has 50 points to make up. Every book says to use stops, but it is often a bad idea. Before you recoil in horror, consider that I know a futures trader who steadily makes $200,000-$400,000 every year, and he never uses stops.

A stop takes only one aspect of analysis into account: price. There is much more to analysis than price. A stop also makes you lazy. If the market and your analysis turn against you, you are prone to think, "Well, if the market takes my stop, then I'm out." But if you have already decided that your position is wrong, you should already be out! On the flip side, when you already have a stop in and decide it's in the wrong place, there is a psychological impediment to widening it. If you don't act, the stop is typically taken out, and then the market turns your way without you. So it can hurt you two ways.

So what should a trader use in place of stops?

Bob Prechter: A trader should use real-time analysis. The question isn't so much whether a level is broken but what the analysis indicates as it breaks. Suppose you are short, and the market gaps up one morning. This could be a breakaway or an exhaustion gap, so at the time of the opening, you might have little knowledge of which it might be. Then suppose the market runs ticks hard but to a lower peak than earlier in the rally, which is typical of exhaustion gaps. Shortly after the high, you see a dramatic reversal in the 60-minute bar and non-confirmations against highs of the previous week in related market averages. At that point, the bear evidence becomes bigger than the bullish evidence, and your analysis tells you to stay short.

When entering a position, you have to give the market time to bounce around against you as it creates the bottom or top. That process almost always involves stopping most traders out with fancy footwork before really heading in the direction they expected in the first place. Most stops are harmful because where you decide is a cautious "too far" is where everyone else thinks is too far, so that's where everybody's stops are. The only way to make money is to let the market work itself out.

So what is the alternative?

Bob Prechter: Once you have a strong indication from your analysis and decide to take a position, place a stop at a "horror" level in case of disaster with the idea that you would never hold your position all the way to that point under normal circumstances. Then, watch the market. Every day, sometimes every hour, you get more information. You might have a bearish opinion but find that suddenly the put/call ratios (or some reliable sentiment indicator) shows traders shorting the market heavily for three days in a row. Now the analysis is telling you to be cautious or get out of your position or perhaps go long. It is a more sensible reason to act than a price stop.

What do you say to those who insist that without stops, they would get killed?

Bob Prechter: I say, you are trading with too much leverage. Leverage forces you out so often that all you will have after years of trading is a long string of losses from stop-outs. Trade well within your capital so that you can allow the market time to respond to the forces that you detect developing in your analysis. If you cannot watch the market closely or do not have time to do analysis (or don't have someone doing it for you), you shouldn't be trading in the first place. Aside from all that, there may in fact be occasional times for close stops. But treat them as exceptions that analysis demands.

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Bob Prechter, CMT
Elliott Wave International

Robert Prechter, Chartered Market Technician, is the world's foremost expert on and proponent of the deflationary scenario. Prechter is the founder and CEO of Elliott Wave International, author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

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