How do you set your stop losses?

  Stop losses are not perfect, but they are the best thing you can do to protect your gains other than buying protective puts on long stock positions. A stop loss is designed to automatically trigger a sale of a security when that security hits a target price.

This works fine when the stock is gradually falling: when the stock dips to the target price, you are taken out. Problem is, stop losses do not do any good when you need them the most, i.e., when a stock drops catastrophically on bad news or for some other reason. When that happens, the stock price can gap below your stop loss price. When that happens, your stop loss order then becomes a market order and you are taken out at the next level at which the stock trades. In other words, if a stock is trading at 80 and you have a stop at 75, if the stock gaps down to 65, you are taken out at 65. Not what you had in mind. Moreover, how many times have you seen a stock gap down and then bounce back up above your stop loss order price? That is really frustrating. You are trying to be responsible and get hammered for it. If you were out for coffee, you would have been okay, or at least able to get out at a better price.

There is a 'stop limit' order you can use. This is different in that the price you set is the price you want to be taken out at. If the stock gaps below that price, your order is not converted to a market order, but is a limit order at the target price. If the stock then rises back to the stop limit price, you are hit at that price. Again, not the perfect solution, but it keeps you from being taken out at the bottom which is what a stop loss order pretty much guarantees when there is a large gap down in a stock. And let's face it, when you need a stop loss the most is the situation where a catastrophic drop comes.

Nothing beats watching a stock, but even that will not save you from a gap down-that is a fact of life. You can buy protective puts, but you have to anticipate bad news. It can be done (e.g., earnings time), but you have to come out of pocket with cash, and that raises your breakeven point. What we prefer is to anticipate when bad times are ahead (a market top), and be ready to act. We can usually close positions quickly and take the other side of the fence to capture gains on the downside. In short, nothing is perfect to preserve your capital when unexpected bad news hits your stock.

Given that, in setting stops to protect profits in normal market volatility, we look for support levels. If a support line is strong (solid breakout, the stock spend a lot of time at that level), the stock should hold above that level. It could trade below it intra-day, however, and that adds to the art of setting stops. If support is close at hand, depending upon what type of stock we are playing (volatile internet or stable Home Depot), we will pick a spot at some point below support, looking at the intra-day lows the stock hit when it traded around that support level to determine our stop position.

If a stock has raced up well above any support as we have seen lately, setting a stop at support could mean a loss of $20-$30 points before support is hit. If we have that much profit, why would we want to lose it all and still get taken out if our stop was hit? What we need to do is look at the daily trading range of the stock, especially when it starts to get volatile as when it reaches a peak in price before a pullback and consolidation. Look at past tops-how large of a range did that stock trade in? Give it that cushion if your goal is to try and ride out a consolidation and let a stock continue to run. Does the stock pull back 25% after a gain, 30%, 50%? They tend to maintain the same pattern on a run. Use that as your guide. When we have a big run in a stock and it is showing signs of topping, we will start paying closer attention-common sense. We will also determine if we want to ride out a pullback or keep our profit and get back in when the stock starts back up. This is the trickiest part of stops. If you set your stops too close on CSCO throughout its run the past five or more years, you would have sold out.

Once we get a significant amount of profit built in on a long term hold, we usually let it alone if we think it is going higher. We will sell calls against the position when its starts a pullback, but we don't want to lose the stock, so we don't use a stop. We may ultimately want to sell if it breaks a trendline, but we have time to make that decision and can place the sell order at that time. We own a lot of CMGI at $30 and less. We don't set stops on it, even during last summer's correction. We knew we were going to hold onto it. If we had set stops, we would have had to get back in-that is not as easy to do once you have been stopped out as emotions take over ("I was already stopped out, it will just happen again. Better to find another stock," or "it has already gone up so much, surely it cannot go up more.").

If we have a short term play we are trying to ride until it tops, if no support is close at hand, we set stops at a level where we are able to keep a good chunk of our profit. It is then incumbent upon us to get back in when the stock improves and is in a buy position again.

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