“If you do not manage the risk, eventually they will carry you out.” – Larry Hite
In a previous tip, we discussed Cutting Losses To Avoid Disaster. One of the best ways to effectively cut losses is to automate the process with a stop-loss order. In that post, I explained that while you have no control over a stock’s behavior, you can control how you behave and when you exit a position. An automated stop-loss order is a great way to force yourself to stick to the plan.
A stop-loss order is an order that you can place with your broker instructing them to automatically sell your position if the price drops to a specified level. For example, if you were to purchase AAPL at $423.00 you might decide that you want to exit if it drops to $400. After purchasing the stock, you can immediately place a stop-loss order with your broker at $400. Then, if the stock would drop to $400.00 your sell order would automatically be executed.
Types Of Stop-Loss Orders
While stop-loss orders can protect your downside exposure no matter where you set them, different traders have different approaches to setting them.
Fixed Percentage Stops
Many investors recommend using the same fixed percentage stop on any position. Famous traders like Jesse Livermore and Gerald Loeb advised exiting any position that posted a 10% loss. William O’Neil, who wrote How To Make Money In Stocks and founded Investor’s Business Daily, recommends cutting your losses at 7-8%.
To calculate where to place a fixed-percentage stop, simply multiply your purchase price by the percent you want to use and subtract that number from the purchase price. This will give you the price where you should exit the position.
Volatility Based Stops
The fixed percentage stops treat every stock equally. Using volatility based stops treat each stock differently based on how much a stock moves on a given day. For example, despite being very close in price, RAX is a much more volatile stock than MSFT. Therefore, a position in the young and explosive RAX might need more room to breath than a position in the mature MSFT.
One of the most common ways to account for a stock’s volatility in setting stops is to use Average True Range (ATR). This is a moving average of a stock’s range over a given number (usually 14) of days. Traders who use ATR to set stops use a multiple of that ATR that they feel comfortable with.
Many investors like to protect their profits in a position by using what is called a Trailing Stop. This is when the trader increases the stop price as the position grows. This ensures that even if your stock drops, you will still lock in some of your current profit.
Dangers Of Using Stop-Loss Orders
While stop-loss orders can be a valuable tool in your arsenal, there are a few concerns to keep in mind when using them.
One concern with using stop-losses is that they still leave you exposed if the stock you hold gaps down past your stop-loss point. If this happens, your order will be executed at whatever price the market will take it. This can incur tremendous losses to your portfolio.
You can protect yourself against these down gaps by trading high quality stocks with a proven track record and monitoring them very closely. As long as you are trading the highest caliber stocks, the number of down gaps should be very limited. Also, if you are a disciplined trader, you would likely sell your position after a tremendous down gap anyways.
Adjusting Your Stops
Another danger that comes with using stop-loss orders is rationalizing reasons to lower the stop, thus increasing the loss you are willing to take. This happens to traders who are not willing to admit that they are wrong.
There are hundreds of reasons you can give to convince yourself that a bad position might turn around. Most of them involve more hope than facts. If you decided to exit at a certain price when you purchased a stock, you must have the discipline to hold yourself to that price if the stock drops to it.
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