If you are learning to invest, then one of the most important techniques to understand is the stop loss order. A stop loss order helps to protect you from loosing more money that you wish based on a predetermined exit strategy. Ideally you establish the initial stop loss price as a part of your due diligence when researching a stock. You should always know your stop loss price before you enter your buy order. Establishing your stop price when you are analyzing your company helps take the emotion out of when you need to execute the order.  Let us go over why do you need a stop loss order, what is a stop loss order, what are the pros and cons, and how do you use the stop loss order to limit losses and lock in profits?

Why do you need a stop loss order?

We have all bought a stock we were sure was going to be a winner only to watch it drop right after you bought it?  The fundamentals are right.  The chart formation was right and the volume was above average.  I like the company's products.  So I will just hold on and wait for it to recover.

But it drops further.  Now you are getting that sick feeling in your stomach.  But you keep holding on, hoping it will recover.  So you wait and it drops further.

There are two problems with hanging on to a stock that's gone down since you bought it.  One: the stock may be declining for some reason you're not aware and may never go up again (or take a darn long time doing so.) and Two: the money invested in this stock could be invested in something else that's going up.

In his best-selling book, How to Make Money in Stocks, William O'Neil compares the situation to running a business, say a store selling women's fashions.  If the store is selling a line of dresses in three colors, red, green and yellow, and the red ones sell out quickly, half the green ones sell, but the yellow dresses don't move at all, what does the merchant do?

Does she order more yellow dresses?  Does she tie up more money in inventory that is not selling?  No!  She puts the yellow dresses on sale.  And she keeps slashing prices to get rid of them.  She wants to get her money out of the "dogs" and put them into buying more of the hot sellers.

Well, investing is a business too.  And if your stock is a dog, sell it and move on.

Yet, this is probably one of the hardest things for an investor to do.  Many, if not most people, get emotionally involved in their stocks.  If "their" pick does not pan out, they do not want to admit failure and defeat.  They want to hang on and be vindicated.  Yeah! I'm smart.  My stock came through after all!

But it is not a reflection on you at all.  A stock does what a stock's gotta do.  If the market dictates that the stock go down, even though you're sure it should be going up, don't argue with the market.  Don't take it personally.

The business woman doesn't take it personally that her yellow dresses aren't selling.  She takes action to rectify the situation.  So should you.

There is another reason you should take losses quickly if they develop, and that is the ability to recover losses.  If a stock drops 10% from the purchase price, you can make it back with an 11% gain.  If it drops 20% you can make it back with a 25% gain.  But if it drops 50%, your stock must gain 100% just to break even!  Check out the table below for the sobering numbers.

What is a Stop loss order?

A stop loss order is an order you place with your broker or enter through your online system to sell a stock once it reaches a certain price.  It is designed to stop a loss or lock in a profit when a stock is above your entry order.  For example, let's say C.J., our day trader, bought Google (GOOG) for $450 per share.  Immediately after her buy order was executed she set her stop at $439 based on her reading of the charts (it was the top of a recent gap).  If GOOG drops to $439, her shares will be sold at the prevailing market price, limiting her loss to approximately $11 per share plus commissions and slippage ($450-439).

Some people establish their stop loss orders with their brokers or online discount brokers.  This allows the stop to be triggered at the agreed upon price.  Others believe that it is better to keep the stop price to themselves and then execute a sell order when the price reaches their predetermined point.  There are pros and cons of each approach.

Pros and Cons

Let's first examine the pros and cons of setting a "hard stop with a broker (full commission or discount).  An established stop order with a broker means you do not have to monitor the action of your stock continuously.  You can even go on vacation knowing that your stop is there to protect you.  Another advantage is to determine the stop price when you are doing your stock homework.  This removes the emotion when watching the stock fall and is especially true for those who want to keep their stop price to themselves and not "tell" the market the price they are willing to sell.  Many people let a stock fall through their predetermined top price hoping it will go back up, so they do not initiate the sell.  It then continues to fall and they incur a much larger loss.  Entering a stop loss order when you are not emotionally focused on the price movement helps to maintain your trading discipline.  Finally, you only pay for a stop loss order when the order executes, so there is no extra charge for the added piece of mind.

One disadvantage is the stop price could be activated by a short term drop in the price of your stock, before it resumes its upward move causing you to miss out on a nice profit.  This can be caused by the normal short term fluctuation of the stock.  Setting a stop that is within the short term trading range of a stock will most likely cause it to execute and cause you a loss.

Another disadvantage is when you enter a stop loss order, it is placed on the books of the market makers who make a market in that stock.  It never ceases to amaze me that a stop will be hit, forming a short term low and then move up again.  There is a belief among experienced traders that market makers move a stock down to the stop to get more shares for their account, since they believe the stock will rise again.  Remember, they see all outstanding buy and sell orders, so they can judge the overall demand for the stock and, thus, whether the price will rise or continue to fall.

Something to keep in mind is that a stop loss order becomes a market order when it is triggered.  As a result it will execute at the then prevailing price, which might not be at the price you set.  Normally this is not a problem, however, if a stock is falling precipitously, then you might have your order completed at a much lower price.  This is one form of slippage.  You could enter a stop limit order rather than a stop order.  The difference is that a stop limit order becomes a limit order when the predetermined price is hit.  This helps you control the price of your sell order.  However, it does not guarantee that the order will execute.  If the stock's price never trades at the specified price it may continue to fall and you will still own the stock.

Techniques to Effectively use Stop Orders

There are several widely used ways to set your stop loss order and each has their advantages and disadvantages.  Nothing in life and trading is free.  The first way is to set your stop at a set percentage below your purchase price.  This limits your loss to whatever percent is used.  For example, T.J. just bought Microsoft (MSFT) at 25.9 on July 19, 2005 on and part of his discipline is to set his stops at 5% below his purchase price.  Therefore, the stop for MSFT would be 24.61, or 5% below his purchase price.  T.J. uses 5% to limit his down side risk.  MSFT hit a new high on August 5, 2005 of 27.68.  This raises his stop to 26.30.  On September 13, 2006 MSFT hit this stop for a profit of $.40 or 1.5%.

Other investors use different percentages to limit their down side risk on each trade, such as 10% or 25%.  Deciding how much you are willing to risk is a personal decision based on your ability to handle risk and your assessment of your stock.  There are no hard and fast rules for the level at which stops should be placed.  This totally depends on your individual investing style: an active trader might use 2.5% while a long-term investor might choose 15% or more.

Another way to set the trailing stop percentage is using the daily average volatility of the stock.  To determine the average volatility compute the average daily high-low price range for the prior month, multiply by 2, and then divide the result by the current low price.  This will give you the percentage stop based on volatility.  Let's again use MSFT, this time for the month of July 2005.

The difference column is the intraday high minus the low.  The average of the differences for the month is  .346.  Based on testing by Thomas Bulkowski, 2 seems to be the best multiplier to keep from being stopped out to early.  Multiply the average difference of .346 by 2 to get the volatility, or .69.  Converting this number to a percent gives us .69/25.35=2.7%, using the low from the last day of the month which is 25.35.  This places your stop at 24.67.  Keep in mind that this stop will rise with each new high achieved by MSFT.  On August 5, 2005 MSFT achieved a high of 27.68.  Assuming you kept the same percentage, your new stop price would be 26.93 (27.68x(1-.027))=26.93.  On August 8, 2005 your stop would have been triggered for a very nice profit of $1.03 per share or 4% in less than a month.  You can recalculate the average volatility difference each month, however, unless there is a definite change in the volatility of the stock it usually is not necessary.

Now all you have to do is decide which percentage stop to use, while keeping in mind that your choice of the percent you are willing to risk will greatly impact the risk tolerance percentage option.  For your information, I prefer the volatility percentage as it provides a more logical stop when I use a percentage stop.  By the way, many online brokers allow you to set the stop based on a percentage. 

The second way to establish a stop loss is to set your price a set number of points below your purchase price. This method is very similar to the trailing percent method, only you use a set number of points below the high price, instead of a percentage.  If the price reverses direction, the stop remains at its previous level and will be activated if the price falls by more than the trailing points.  The trigger price is readjusted each time a new high is reached.

So how do you determine what number of points to set your trailing price?  Actually, it is just like using a trailing percent, except you use number of points.  Again the key factors to consider are your risk tolerance and the volatility you can handle.  Review once again the paragraphs on Trailing Percent to see how to determine your trailing points.  The only thing you change from the trailing percent is instead of using a percentage to trail your stop you are actually using the number of points.

The only difference in Trailing Points vs. Trailing Percent is the trailing percent is proportional, so there will be a slight variance in the absolute stop.  Other than that, there is no difference in the use of the two methods.

The third way uses the market psychology that is portrayed in the price and volume patterns of each stock.  Stocks have levels that tend to act as support.  Traders and investors who are interested in a company, are seeking to get in at a good price.  As a stock moves lower these people initiate purchase orders that act as support for the stock.  For more on identifying support levels please see our Traders page as well as Stan Weinstein's Secrets For Profiting in Bull and Bear Markets

Using T.J.'s Microsoft chart we can see support has formed in the 26-26.5 area.

Using this chart T.J could set his stop just below 26, say 25.93.  This provides a buffer just below support so he is unlikely to have his position "taken out" on a dip to support, yet he is protected from losing more should the stock continue to fall.  The reason we like this approach to setting stops is there is a rational logic to it and not just an arbitrary number assigned like a percent or absolute number.

While stop loss orders are usually considered a way to limit losses, after all that is its name, they are also useful to lock in profits.  Using the stop as a "trailing stop order" you can adjust your stop upward as the price of your stock rises.  The trailing stop order can be set as a percentage or a set number of points below the bid price.  Or it can be set just below the next support level of the rising stock.  Yes, you are right, we prefer set the stop just below the next support level.  That is the technique we used in our example on the Introduction to Technical Analysis page.  This technique lets you lock in your unrealized profits and gives you room for the stock to continue to rise, letting your profits run.

Conclusion

The profit loss is a simple, easy to use tool.  It helps you prevent unnecessary losses, encourages you to analyze the risk you are taking when buying, helps manage your capital and allows you to lock in unrealized gains while letting your profits run.  Never trade or invest with out it.  Also please see out piece on Trailing Stops.