Ask The Trader
Wednesday, March 14, 2001
Think Stop Before You Go
Do you have any suggestions as to how to go about placing stops? I just started using stops since the market has been so unpredictable but I am not confident as to where they should placed.
Stops are an efficient way for traders to limit losses while largely removing the psychological pain of taking those losses. Every good trader realizes that not every trade will be a winner. In fact, for most traders, the bulk of their trades will be losing trades. The key to coming out ahead is to limit your losses (don't allow any one trade take a debilitating bite out of your trading capital) and to let your winners run.
A stop order is simply an order to sell a stock if it drops to a certain level. The nice thing about this type of order is that you don't have to be watching the market for it to be activated and it prevents you from second-guessing your decision to limit your losses (provided you leave it in place).
There are many different strategies for placing stops, but most deal with using support levels in conjunction with the amount of money you are willing to risk in order to capture a predetermined amount of profit from a trade. Yes, this means you actually have to think about risk/reward before you get into a trade, but believe me this will keep you out of many trades that you never should have pulled the trigger on in the first place.
Once you have determined the amount you are willing to risk (Splittrader commonly uses the 8-10% rule) you then search for a level of support that closely matches your downside risk level. It is here that your stop order should be placed and should be left in place NO MATTER WHAT.
If the stock moves in your favor, your stop should be ratcheted higher in order to lock in gains. This is commonly called a trailing stop and it prevents the trader from falling victim to his/her biggest enemy, greed. How often have you watched a stock rocket higher providing you with a nice profit, only to see it fall right back and leave you with a loss?
Trailing stops work the same as regular stops in that you keep your risk in mind, but here, since you have a profit, you have to ask yourself, "What level of profits did I shoot for going into this trade and what level makes sense when compared with the risk I took?" Often times a support level will not coincide with your trailing stop level, but here it is more important to lock in gains then to force a fit to a support level. Lastly, NEVER be disappointed with taking a gain. Often time a stock will come back to hit your trailing stop then rocket higher. As traders, we need to be confident that we made the right decision and move on. Otherwise we will start to doubt ourselves and will end up entering trades at inopportune times.
Good Luck and Have a Profitable Trading Day
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