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  Category: Articles » Finance » Investing » Article

When And When Not To Use A Stop

By Larry Potter

A stop loss order is simply a trailing "safety net" that you can attach to a stock buy. The purpose of a stop loss order is
to keep you from being "trapped" in a stock that falls a ton of points. It is all done electronically and it is both easy to
use and quite mandatory in our opinion.

Many times you will hear ..Know your exit before you go in. On the downside though. For instance there are going to be times when you make a trade and it goes against you. That is normal and it happens to every trader. The difference is that if your trade was fundamentally flawed (you bought a stock thinking it would make a short term run but it fizzled out instead) you should have a set predetermined price that you will let that stock fall to and you are out.

For instance lets say we think the XYZ company is going to fly because of a hot news release and we buy 500 shares. but almost instantly the thing starts backing up and soon we are down a couple points. Do you hold or do you sell? Since we were looking for a run up over the news, and it was greeted with selling it was probably best in this instance to sell out and take our loss and move on to a winning trade. But what if you buy a great company and because of market conditions or whatever, you are faced with your stock falling on you? That is where stop loss orders come in.

Let's say we bought into XYZ and XYZ was a great company . We think that it has the ability to go for many points and history shows us that it already has in the past. So we buy it BUT we attach a "stop loss order" to it. What that means is that we are going to tell the broker just exactly how far we are going to let XYZ fall before we sell and take our loss. Let's assume XYZ is selling for 100 dollars a share and we know that it often bounces up and down about 2- 3 points in a normal days range. We might want to tell the brokerage that we would like to sell out at say ..96 dollars per share if it falls that far.

That is a stop loss order and it is attached to your account electronically. They will ask if you want that order good for
the day, or good till cancel which simply means do you want the sale to fire off if the stock hits 96 dollars today only, or for the next 60 days (that is about the range of a good til cancel order). Let's say we tell them it's a "GTC". So from the time you bought XYZ , and for the next 60 days or so if XYZ falls to 96 or lower it will trigger your sell program and you will take your loss.

The use of stops on every trade is suggested. The reason is quite simple. If you know the "average" daily range a stock seems to travel in and it falls out of that range, who knows where the bottom might be. A stop loss order will sell you out at a loss for sure, but it will save you from the nightmare of coming home to find your stock got slammed and now you own it but it's down 30 points.

Now for some things that a stop loss order will not solve.. first if your company announces something bad before the bell and it gaps down 15 points on the open, your order will fire, but it will sell you out at that low. Sometimes in that instance it is better to cancel your stop loss and hope that it rebounds. ( the thinking is like this, the order couldn't save you, so since you have two choices sell it at that low or hold it hoping for some type of nice rebound, often its better to hold it.)

Another problem is that if a company starts to tank real hard your stop may get "run through" or in other words stop loss orders are basically market orders to sell and if the stock is moving down quickly if the order to sell was at 96, it might fall all the way to 94 before you get filled.

There always will be a battle between simply holding on to a stock and hoping to recover your losses with time,
versus stopping out and taking a quick loss. It probably best to keep pretty tight stops on and take small losses along the way as we trade and gain profits on ones that move for us.

One thing not advocated is having a predetermined "sell point" on the upside. For instance if we buy XYZ and it goes up for us 4 points today, sure we could take our profit and go, but instead we simply like to move our stop loss up closer to its new level. This way if it falls back we will get stopped out but we will still have a nice profit, but if it continues up we will simply keep moving the stop up. There is no limit to how many times you can move a stop loss order and we often will move the point up on an hourly basis if the stock is moving up well.

Let's say XYZ was 100 and we had a 96 dollar stop loss on it. Now XYZ goes to 104 today. We simply move our stop up to say 102. Now if it goes to 106 we in turn go to a stop of 104, etc.. This way we can still capture a lot of upside as it keeps growing.

I know how hard it is to watch a stock get "stopped out" only to rebound a few days later, but sometimes its a long way down before they stop falling. Stops really do work, and after "crunching " the numbers of getting stopped out versus the risks of holding on ...getting stopped out makes more monetary sense as far as having cash to trade with.
About the Author
Larry Potter is a recognized authority on the subject of trading. For a FREE report on HOW TO TRADE FAST from
Stocks2Watch®, go here: How To Trade Fast

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