What is a good rule of thumb for setting stops? (July 8, 2000)
What level you use for stops depends upon whether you are trading stock or options, if you just bought into a position or have some profit built into it, and personal preference, just to hit the high points.
For stock purchases, don't let your loss exceed 7%-8% from your buy point. That way, if a stock tanks, you won't lose more than 7%-8% and you are still able to play the game. If it turns back up and starts acting the way you wanted it too, you can always get back in. For options we relax that a bit since they are somewhat more volatile due to the less controlled environment where market makers rule the landscape, juggling the spread based on the orders, open interests, volume, expiration date, etc. On option purchases we maintain a loose 25% rule. In no event will we ride an option below 50% of the purchase price.
Once we have some profit built in we can change our loss point. We don't want to let a profit evaporate on us; this was particularly true 2-3 months ago with all of the market volatility. We would move up stop loss orders right behind our stock or option as they moved up to avoid the gains running right back down on us. Now that the market is acting in a healthier manner with stocks using their 10 and 18 day moving averages as support on pullbacks, we will let a stock fall back to that area if it is not too far over it. For example, PLXS recently hit an intraday high of 122, then pulled back to 108.75 on its low the next day. That was its 10 day moving average, and it bounced off of that intraday, and then jumped back up on rising, above average volume on Friday. Textbook case of a market leader bouncing off of its 10 day moving average, but it was not $30 over that level as was SDLI when it hit its high before pulling back. On a percentage basis, that was not any more than PLXS, but when playing options, do you want to ride a big move up back down, or do you want to bag the profit now and buy back in? With a wasting asset, we often play that strategy unless we are in options with an expiration 4-5 months out where we can afford to ride the move.
When we own stock in a company that is leading the pack in a healthy market, however, we will tend to let it run up and down, using either the 10 or 18 day moving average as our stop point. The reason? Strong stocks tend to use those levels as support. Look back at the stock's recent history and see which level it used. Coming out of a correction, that may not help. Right now we are seeing one stock use its 10 day moving average while the next uses its 18 day moving average. We prefer the 10 day moving average, and we use exponential.
Much depends on where you bought in. If the 10 or 18 day moving average is greater than 7%-8% below your buy point, that is not the level to use. If you have profit built in that those levels will not violate your sell rules, just below those levels can be great stop loss points. We say just below since the stock can hit or fall slightly below intraday. Place your order under that level $1-$2 if you are intent on using this method, again using the particular stock's past history as a rough guide.
Right now we are giving our stock purchases some room, but not a lot. We have seen some leaders crash back down into their bases, while others have hit support and turned right back up. This rally is still not foolproof, and after April and May, we would rather be vigilant, take some profit or cut a loss short, and then re-enter a play if it turns back up. Big winners can double for us, but we are not going to let them give back the gains we just made. With our options plays, we are being patient, but not too patient. For example, we had purchased some SEBL August 155 call options on June 30. The stock was up and down, but then broke out Friday on decent but not great volume. On its high the stock hit 177.06 before closing at 170.94; breakout price, but volume was not quite there. We had calculated we would pull the trigger on SEBL options when it hit 175 if volume was not huge on the move. We did some math and put in an order to sell the options at 29.50 (purchased at 19.50). Friday the stock ran too 177 and we were taken out. We felt it might pull back if the volume was not there, so we were willing to sell and wait for the next move. We banked some profit, SEBL pulled back as expected, and now we will be looking for the big volume breakout for more calls and selling some puts.
Finally, personal preference and risk factors play the biggest role. If you have good profit on some options and a stock is hitting resistance or showing signs of topping (finishing off of its high on high volume, going nowhere on high volume, a.k.a., churning, making smaller gains on slowing volume), we often move the stops up tighter to save more profit. We may even set a target as with SEBL that we will sell at if hit. Where? At the previous day's low trade or where we feel comfortable on the trade. If we have a 40% gain, do we want to risk losing 10% if we think it is topping? Why not sell right now or tighten your stops and take a 35% gain if you are happy? If the stock pulls back a bit and takes back off, get back in. There is a wash sales provision in the IRS code, but if you are taking profits, that really is not an issue. That comes into play if you have a loss and a gain in the same stock within a short period of time and want to write the loss off against the gain. Again, if you are taking more profit, that is always better than less profit or a loss.
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