Stop Losses to Protect Capital

You place stop loss orders with your broker to automatically close a position if its price gets to a certain level (the “stop”). Sometimes news related to a stock can cause its price to change a lot during a day. Stop loss orders keeps these positions from having catastrophic losses. Closing positions is where many beginner stock traders fail. Proper stop management is key to success!

I never hold a stock position without a good-till-canceled stop order. Otherwise all the money I have in the position is at risk: it could go to $0! There are many ways to determine where to put your stop.

The simplest stop is to place it a percent below (long position) or above (short position) your cost per share. Another is to use a trailing stop. This stop automatically adjusts to be a percent of the highest high (long) or lowest low (short). Beginner stock traders overuse this technique, often using tight trailing stops like 5%. Using stops that are too close to the opening price will not give enough room for the stock to move into profit. Many stocks are volatile and need room to move without getting stopped out. Generally I only use trailing stops if I decide to close a position but think it might keep making profit. In that case I will use a tight (2-3%) trailing stop.

Chart readers often set stops near support (long) or resistance (short). Determining support and resistance is more an art than a science. Several trading systems I used were based on support and resistance. I prefer to put these kind of stops just beyond support or resistance, since I assume many other stock traders are using support/resistance. This keeps me from getting stopped out when the market makers “run the stops.”

You can also use mental stops. These are stops you do not place orders with your broker. Instead you check the stock price yourself and compare it to your stop. I often use mental stops with closing prices, while also having wider stops placed with my broker.

An advanced technique which I also use is adaptive stops. Instead of keeping the stop price fixed during the entire trade, it is adjusted during the trade based on how the stock price moves and how long the trade has been on.  This tends to prevent winners from turning into losers, replaces positions that have gone nowhere, locks in profits and reduces the amount at risk. See When to Close a Stock Trade for more information on this.

I also avoid placing stops that end in 0. For example, I avoid stops at 2.00, 1.50, 10.10. Why? Because many people round their stops and I don’t want my stop to be where many others have theirs.

The recommended stops given in the High Performing System I use have been optimized to reduce risk without significantly lowering returns. However, broker-placed stop losses are not used in the hypothetical back test results. All trading decisions in the simulation are based only on closing prices.

Please ask your questions or share your experiences with stops by leaving a comment.

Tags: beginner traders, stops

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