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Intro to Stop Losses

Use Stop Loss Orders to Limit Your Losses–and Let Your Profits Run!

 

There is no question that the habitual use of well-placed stop-loss orders will tend to keep losses small when stocks plunge (you may substitute “drop,” “fall,” “decline,” or any term that means “asset loss”).  In order to minimize the risk of substantial loss if the worst scenario occurs, the most successful traders always place a “stop loss” order.  That is, they place an order with their broker to sell if the price drops to a specific lower price.  The whole point of the stop loss is to automatically sell the stock if it drops to that specified price, and hopefully, before it drops any more.  The exception to this is the trader who uses “mental” stop losses.  We will discuss this stop loss later. 

An example of a “stop loss” order is if a person says to the broker “I want to place a sell stop order for 100 shares of XYZ at $X.”   The term “stop loss” can be used instead of the term “sell stop.”  The broker understands that when a person says “stop-loss,” it is really “sell stop” that is meant (“sell stop” is the more technically accurate term).  The stop loss order either stays in effect for a certain period of time or it is “Good-Till-Canceled.”  While the stop loss order remains in effect, if the stock falls to the specified price, the “stop loss” order will automatically convert to a “market order.”  That means your broker will automatically (and without the need for further instruction) sell the stock at the next market price available.

How do you know where to place the stop loss order?  Traders and investors will usually set the stop loss somewhat below a region of support.  If the stock is trading at $50, is in a rising trend, and the trendline defining its rise is currently at $48 (trendlines represent support), a trader might place the stop loss at $47.  Stop losses may be based on where demand (support) exists for the stock, on a certain percentage drop, or on a drop that is more than can be accounted for by the normal fluctuations or volatility of the stock.  Of the three, the first and last are much more effective.  The market does not “care” about percentages or what you pay for a stock.  A drop of X% below your purchase price “means” nothing to the market.  The market tends to pay much more attention to its own patterns.  

For example, during the 7 days after Dell’s stock gapped up on 10/29/07, the stock’s pattern showed probable short-term support at $29.40.  A trader might place his stop-loss order at $28.25 (a long-term investor would place it lower).  By 11/08/07 the stock had dropped to $27.90.  This move would have triggered an automatic sell order “at the market” as the stock’s price passed through $28.25.  The stock continued to drop.  By 2/7/08 its low price was $18.87.  This stop loss order would have protected the trader from a further decline of over 33%.

However, the stop loss order placed at $28.25 may not have actually been executed at that price.  It became a “market order” when the stock fell to that price.  The order would therefore have been executed at the best price available for the next transaction.  That means the stop loss could be executed at a higher or lower price than the price at which the stop loss order is set.  The stock could even gap down from above to well below the price set by your stop loss order.  Even if that happens and your stop loss is triggered, it is probably a good thing to be rid of the stock because it’s likely that it is in real trouble.

In setting your stop loss, remember to ask yourself how much of your entire portfolio you are willing to lose on each position and plan accordingly. If you have 15 positions, a stop loss of 15% will cause a portfolio loss of 1% if the stop loss is triggered. On the other hand, if all your money is in one position, that stop loss will cause the portfolio to lose 15% if it is triggered.

Traders often use trailing stop loss orders to lock in profits.  As a stock rises, they keep increasing the price at which the stop loss will be triggered.  The method of adjusting the stop loss is usually based on the same principles used for the initial stop loss.  However, there may be variations.  If the initial stop loss was based on the purchase price, subsequent stop losses may be based on the highest low, highest close, or highest high since the purchase.  Alternatively, the trailing stop loss may be placed in reference to some form of support.

Look at your purchase from a practical perspective.  If you buy a stock that is 15% above its support, then a stop loss placed 8% below the purchase price is a meaningless stop loss.  Trending stocks tend to revisit the rising support levels represented by the trendline.  Hence your 8% stop loss will likely be triggered without anything significant having happened.  If, on the other hand, you buy when the stock is only 1% to 2% above support, your 8% stop loss will not be triggered unless the stock falls enough to penetrate all the support just above your stop loss (in this case that’s a penetration of 6% or more, and it is not easy to punch through that much support).  That support represents buyers.  If there is sufficient selling to overwhelm all the buyers just above your stop loss (and there has been if your stop loss is triggered), then something very significant and very negative has happened.  Under those conditions, you want your stop loss to be executed.

Swing traders should adjust their stop loss daily.  Intermediate term and long term investors might get by with weekly stop loss adjustments.  Most swing traders like to capture gains achieved over a few days to a month.  Now let’s illustrate how they might do this using some of the methods mentioned earlier. For example, a swing trader (they hold more than a day but usually less than a month) might use a stop loss that ranges between 1% and 3%.  However, since this stop loss range is expressed as a percent, it is not entirely representative.  More sophisticated traders base their stop losses on the action and volatility of the stock rather than on a straight percentage.  Nevertheless, we’ll use straight percentages here because they are easier to use in an illustration.  These traders might place the stop-loss 1% to 3% below the highest low or close reached by the stock since its purchase or they might place the stop loss 3% below the highest high to lock in most of an upward surge.  One strategy they could use is to keep the stop loss 2% below the highest low until the stock accelerates or surges.  When it surges, they could follow the stock up with the stop loss placed 2% to 3% below the highest high.  More aggressive traders will use even tighter stop losses.  Again, sophisticated traders prefer to base their stop losses on the location of support or on the volatility of the stock rather than on straight percentages, because straight percentages have no meaning relative to a stock’s support or fluctuation behavior.

Stop losses based on volatility or definable support are far less likely to be triggered by a random fluctuation in price.  Some will use a standard deviation calculation or the ATR (average true range) in calculating the stop-loss, but we will not go into those right now.  Others will base their stop-loss on the 20-day (or 4-week) low.  Their thinking is that if the stock falls below the lowest price it has seen in the last 4 weeks, then it is no longer trending upwards.  Therefore they place their stop loss just below that low.  More aggressive traders base their stop-loss on a 10-day low or some shorter period.  If there is a definable trendline, traders will often place their stop loss 3% below the current value of the trendline if closing prices are used and the stop loss is not actually placed with a broker (this is called a “mental” stop loss).  However if the stop loss is to be exercised in real time while the market is open, many traders will place the stop loss a little more than 6% below the current value of the trendline.  The greater distance of the stop loss is to compensate for the fact that there are often intra-day spikes that could unnecessarily trigger the stop-loss.  The closing price is the final valuation given to the stock and it is the price at which traders are most comfortable leaving their money committed overnight.  This figure has less volatility than the low or high.  Therefore stop losses that are based on the close (and therefore are not triggered by intra-day spikes) can be closer.