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Using a stop loss virtually removes the human element from the
emotional decision to sell a stock or cover a short sale. You'll
stop yourself before you destroy your account. With most of your
capital preserved, you'll return to invest another day.
The stop loss is simply a sell order that is placed a point or two
or three below your buy price when you enter a stock position. If
the market goes against your stock and it declines to your stop
price, a market order is automatically triggered to promptly take
you out of the position. The theory is simple: Take a small loss
today rather a big loss tomorrow.
We suggest using a stop loss for nearly every one of our plays. The
placement of the stop can be quite specific, i.e., placing the stop
just below the point where the stock breaks out of a strong chart
pattern. Or it can be general, maybe a couple of points to give the
shares some "wiggle room" during periods of market volatility. In
most cases, we'll set a stop to limit our potential loss to no more
than 10%.
But a stop is for more than downside protection. It should also be
used to lock in profits when a trade is going your way. The
technique is using a "trailing" stop.
Say you bought shares in XYZ at 20 and set your stop loss at 18. A
week later XYZ is at 22. The savvy investor will cancel his old stop
and place a new one at 20. If the stock sells off and hits 20,
you'll be out of the position at break-even. If XYZ continues to
climb to, say, 24, you can put in a new stop at 22 and lock in a two-
point (10%) gain. In a rising market, you might be able to "trail"
the stop below an advancing stock for weeks or months, locking in
additional profits along the way.
(Note: For short sales—which profit when the underlying stock falls--
the stop loss rule applies in reverse. Set the stop loss a few
points ABOVE the entry price and trail it downward as the shares
decline.)
If you work with a traditional broker, he or she can set the stop
loss when you make your purchase. Make sure the broker places a firm
order in the system and doesn't use a "mental" stop like, "Get me
out if it hits 60." That unverifiable type of order got Martha
Stewart into trouble.
If you use an online broker, you can set your stop and adjust it
electronically with a few mouse clicks. You'll probably be asked to
designate your stop as a "day order" that expires at the end of the
trading session, or "good `til cancel," which keeps the order in
place until you remove it. Most brokerages allow good `til cancel
orders to expire after 30 days, so it is important to monitor your
account periodically to adjust your stops and make sure the orders
are still active.
A version of the stop order is the "stop limit" order. In this case,
a sale will occur only at the exact price you determine instead of
at the market.
This protects the investor in case the stock "gaps down" at the open
because of bad news, an earnings disappointment, etc. If you set a
traditional stop at, say, 18, and the stock gaps down at the open to
16, a market order will be triggered and the order will likely fill
around 16. If a stop limit is in place, however, there will not be a
sale at 16 but only if the price drifts back to 18. This sort of gap-
down and bounce-back happens regularly, and a stop limit can save a
lot of money in these cases.
The downside to the stop limit, though, is the possibility that the
price won't recover. Shares could gap down to 16, then drift to 15,
14 or lower before stabilizing. In this situation, the stop limit is
never triggered, and the shareholder must make the agonizing
decision to sell at a much lower price than anticipated or hang onto
the stock in hopes of a rally that may never come.
For more nightly trading tips enter your email address at:
http://clix.to/wallmann
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