As a practical matter, can you explain how you use stops as you define them? Also, how stops vs. stop limits work best when they carry over to the next day? (October 8, 2001)
Stop losses are not perfect, but they are the best thing you can do to protect your gains other than watching the market closely or 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. You can place stops on NYSE stocks, and usually Nasdaq stocks, though if things get volatile, market makers may not take stop orders on Nasdaq stocks.
This works fine when the stock or option is gradually falling: when the stock dips to the target price and a trade is made, you are taken out. Problem is, stop losses (as opposed to stop limit orders) 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 price of the next trade on the stock. In other words, if a stock is trading at 40 and you have a stop at 37, if the stock gaps down to 33, you are taken out at 33 if the stock trades there. 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 you get hammered for it. If you were out for coffee when the news hit and you did not have a stop loss order in, you would have been okay, or at least able to get out at a better price because you would not have been taken out by that stop loss order.
Stop limits are different in that the price you set is the price you want to be taken out at, i.e., a limit order and not a market order. 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 and trades, 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 occurs. If we have some bad news overnight on our stock or on the market as a whole, often we will pull our stop orders to avoid being taken out at the session low or at some point we decide is not the best place. That requires us to watch the stock that day, but it is our money at stake, so we do what we must.
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 or topping signs in our stock as taught in the seminars), and be ready to act. The market or the stock usually gives us those signs ahead of time, though as noted, bad news when the market is closed is something you cannot avoid. 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 or more staid blue chip), 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 on selling. If we have that much profit, why would we want to lose it all and still get taken out if our stop was hit? Much depends upon if this is a long term hold or a short term investment where we are playing a specific trendline move or are trying to capture the gain on a breakout move (perhaps using options). Most stocks breakout and then test the breakout; after that they move up their short term moving averages, bouncing higher and then testing them. They do this 4 to 5 times and then test lower. What is the move we are playing? That is what we have to know so we can put our sell points in such that they match the investment we are making. Use the trendlines and support 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 some huge movers in the 1990's, you would have sold out too soon.
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. Use long term trendlines as your guide along with price/volume action. 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.
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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