This happens to me often. I trade on 1m chart, and I put my SL order reasonable distance outside of the S/R. Right before the stock starts to move in the direction I expect there is a large price spike with low volume that blows away my SL and closes my position. Almost like someone scans for SL orders and does this on purpose [prob not, but sure seems that way sometimes].
Stop hunting is a strategy that attempts to force some market participants out of their positions by driving the price of an asset to a level where many individuals have chosen to set stop-loss orders. The triggering of many stop losses at once typically creates high volatility and can present a unique opportunity for investors who seek to trade in this environment.
- Stop hunting refers to trading action where the volume and price action is threatening to trigger the stops on either side of support and resistance.
- When stops are triggered, price action experiences more volatility on the additional orders hitting the market.
- The volatility creates opportunities for traders to open a long position at a discount or pile onto a short position.
The fact that the price of an asset can experience sharp moves when many stop losses are triggered is exactly why traders engage in stop hunting. The price volatility is useful to traders because it presents potential trading opportunities.
For example, assume that ABC Company's stock is trading at $50.36 and looks as though it may be heading lower. It is possible that many traders will place their stop losses just below $50, at $49.99, so that they can still hold onto the shares and benefit from an upward move while also limiting the downside. If the price falls below $50, traders expect a flood of sell orders as many stop losses are triggered. This will then push the price lower and give some traders the opportunity to profit from the decline and perhaps even open a bullish position on an expected rebound to the previous range.
Stop-loss orders are types of orders that are slightly more complicated than a traditional market order or limit order. In a stop-loss order, an investor will place an order with their broker to sell a security when it reaches a certain price. For example, if you own shares of company XYZ Inc., currently trading at $70, and you want to hedge against a significant decline, one option would be to enter a stop-loss order to sell your XYZ holdings at $68.
If XYZ moves below $68, your stop-loss order is triggered and converts into a market order. Your XYZ holds would be liquidated at the next available price. Stop-loss orders are designed to limit investors’ losses on a long position. A stop-loss order can protect a short position as well.
Stop hunting is relatively straightforward. Any asset with significant enough market volume will be moving in a more or less defined trading zone with areas of support and resistance. The downside stop losses tend to be clustered in a tight band just below resistance, while the upside stop losses sit just above support. Larger traders looking to add to or exit a position can shift the price action with volume trades that amount to stop hunting due to their market impact.
Generally, this will be signaled on the charts by increasing volume with a clear directional push. For example, the price action might bounce off support twice on increasing volume before breaking through. Smaller traders jump on this stop hunting behavior to realize profits from the volatility it creates in the short term. Depending on your strategy and indicators, you can participate in the stop hunting on the downside with a short position or consider it an opportunity to open a long position at a price lower than the recent trading range.
Many are hesitant to invest in the stock market because of the large gaps in prices. It is not uncommon to see a stock that closed the previous session at $55 open the next trading day at $40. This kind of volatility can result in massive losses, but this is the risk that investors take when trying to make money in the stock market.
Regardless of the type of order placed, gaps are events that cannot be avoided. A common strategy is to use stop-loss or limit orders as protection to mitigate the impact of the gap. However, that isn't always the best solution.
- Gaps are often news-driven, with a rush of buyers jumping into or out of a security, propelling it one way or the other.
- Stop-loss orders and limit orders are two ways to protect yourself from losses that occur as a result of gaps.
- Stop-loss orders mean a broker will buy or sell a security when it reaches a specific price, limiting how much an investor might lose on a position.
- A limit order yields a purchase or a sale of a security at a specific price or better.
- Another option is to buy a put option, which means the buyer has the right but not the requirement to sell a certain number of shares at a strike price.
For example, assume you hold a long position in company XYZ. It is trading at $55, and you place a stop-loss order at $50. Your order will be entered once the price moves below $50, but this does not guarantee that you will be taken out at a price near $50. If XYZ's stock price gaps lower and opens at $40, your stop-loss order will turn into a market order and your position will be closed out near $40—rather than $50, as you had hoped. On the other hand, if you decided to enter a limit order to sell at $50 [instead of the stop-loss discussed above] and the stock opened the next day at $40, your limit order would not be filled and you would still hold the shares.
A gap is a technical occurrence in which a security's price spikes or drops at the start of trading versus the previous day's close, with no trading occurring in-between.
As you can see, if you are worried about a gap down in price, you may not want to rely on the standard stop-loss or limit order as protection. As an alternative, you can purchase a put option, which gives the purchaser the right but not the obligation to sell a specific number of shares at a predetermined strike price. The strike price is the price at which a derivative contract can be bought or sold.
Put options can be valuable when there is a depreciation of the underlying stock price in relation to the strike price.
Holding a put option is a good strategy for traders who are worried about losses from large gaps because a put option guarantees that you will be able to close the position at a certain price. However, they do come with certain challenges, most specifically costs associated with long-term protection against gaps and the ever-present issue of timing.
Ultimately, though, put options are probably the surest way to mitigate gap risk, although it requires a level of sophistication and experience to get the timing right.