Using protective stop loss system is of the outmost importance if you want to protect your capital against a major bear market like the ones we had in late spring 2003, spring 2001, in the fall of year 2000, fall 1998, fall of 1997, spring of 1994, fall of 1990 and early in 1990 as well.
In our index trading system there is one signal called Stop Loss (SL) that could be initiated after each buy signal. So let's take a look at what happened in july - august 2004 and we will use SP500 market.
We first had a Lower band touch buy signal on July 16th at 1101.39. From that point the market did not move much for about 10 days to suddenly start to fall more quickly. In our index trading system we calculate the Stop loss after a buy signal the following way :
We take the lower band reading on July 16th at the time of the lower band touch in this case 1100.12
We than take the band width (distance between the moving average and the lower band) on that same day in this case 2.2% or 24.69 points.
We then calculate the stop loss point. Since with we are dealing with SP500 we want a minimum of 3% percent under 1100.12 which is 1057.12. If the band width would be larger than 3% we would take that number.
At that point we don't generate the stop loss signal immediately, we just trigger it only. We will wait the market to recross the lower band to initiate the stop loss signal which occured in this case on August 10 2004 at 1079.04. We then end up with a loss of 22.35 points which is roughly 2%. Doing it this way imporves the result a lot as you can see on the graphic. Selling immediately when we hit our stop point is not a good idea sine our technical indicators are quite oversold. So we wait for a short market rebound to sell limiting this way our losses. We had several situations like this one since 1989 and we managed to improve the performance of our index trading system significantly working this way with our stop loss system.
So far so good. Now we have to get prepared to reenter the market. This could be done in 2 different ways. Let's describe the first way. From the point we had our sell signal we keep in mind the highest high of the day (not the close). Then we compute 1.5 timnes the band width which was in this example 24.69 times 1.5 = 37 points. If the market falls from it's highest point at least 37 points (measured with the low not the close) and takes more than 3 days, we have our reentry into the market. In our example it did not felt enough. So the reentry was triggered by the fact that SP500 recrosses the lower band. So that is our second way to reenter the market.
Of course there could be an exception to that. If the market falls quickly and we encountered an extreme oversold condition at the same time we hit our stop loss point then that condition prevails.
Click here to see how stop loss protection can help profiting in special oversold conditions
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