We will start off with protecting your down side risks and that starts with defense number one, the stop loss order.
They can protect you from a massive loss by limiting how far a stock falls before you sell it. When you buy a stock, you have the ability to attach something to your stock called a stop loss. This simply means that if your stock starts falling an electronic program will sell it for you at a predetermined price. For instance let's say you buy ABC for $100 per share and you know that in the course of a typical day it may move around about 2 points up or down. Now you say to yourself "if this thing falls more than 5 points, there is something wrong and I want to be out". So, you click on "stop loss" and enter a price when trading online or call your broker and say "I want to attach a stop loss order to ABC at $95." (He should ask if that is for the day only or a GTC or "good til canceled" order? GTC just means that for about the next 60 days your order stays on the books). Then, no matter what you are doing or where you are, if the stock falls to the $95 range, your sell order will fire off and you are out of the stock.
Next, you have to consider this. Did you just buy the stock or have you already made money in it? This is very important because when you enter a stock you should be very quick to bail out if it is falling. But, if you have made 10 points in it, you might not mind letting it back up a little more during a down period. So, we recommend that on entering a stock, if all your research and "hunch" tells you this thing is going up and the minute you buy it it starts backing up, you should probably sell. Something is wrong. Keep that initial stop VERY close. Maybe only a couple points, depending on your capital. If you are comfortably up, then the stop can be a bit "relaxed", but never place a stop at less than your initial entry point if you are up on the trade. For instance if you buy ABC at $100 and by the close its $103, your stop becomes $100. If the next day it is 105, adjust your stop to say $102. This way even if you get stopped out you still have a $2 profit per share. This is called a "trailing stop" and you simply adjust it higher as the stock moves higher.
Why are they important? Because when the selling really hits, if you don't have a stop order on your stocks, you may come home to find a very unpleasant thing has occurred. The stock you owned at $100 is now $72. A stop would have prevented that. (note: you may not get sold at the exact price you specify because a stop order is automatically a market order and if the issue is falling fast it may blast right down past your $95 and you don't get sold until $94.50 or even $94) So, unless you can monitor the action all day from home in real time, having a stop order attached is a form of insurance against a big loss.
How many times have you seen a stock fall to your stop point, get sold and then take off again the next day? A lot we're afraid. That is indeed a problem. It hurts and it is humiliating to watch that same stock fall right to your stop, get sold and rocket back up. But for as many times as it hurts to get hit like that, it generally doesn't hurt nearly as much as when "the big one hits". It's like house insurance: you hate to pay for it every year, but if the big one hits, you are saved from total destruction.
Is there anything you can do to keep from getting stopped out so much? Yes, one thing that you can do is get familiar with the stocks daily price swings. For instance every stock "moves" up and down during the course of a day. You can average how much by looking at a daily chart. If the average swing is say 2 points, you have to give it that and then some. But some stocks are extremely volatile. They may move 8 points in a day. Accordingly, you should give it that room and then some.
The next thing that you can do is this, Remember you can take your stops off again too! What good is that? Suppose you are in the ABC company and you paid $95 for it and it is now at $100 and have a $95 stop, then the market gets a bit nasty and it falls to $96. You still own it but you aren't far from getting sold out. The next morning the market looks weak again, such as the futures being down a bit. It seems like everything is going to open a bit lower than it closed. Sometimes its wise to cancel that stop order because if the market opens and the stock gaps down 1 dollar to 95 and you get sold out, it may have been that opening gap that got you. As you know, the first 1/2 hour of trading can be a real roller coaster and nothing is worse than getting stopped out on a gap down opening only to see it rising 15 minutes later. So, removing your order temporarily gives you some control. If the market opens down but very quickly settles out and starts back up, chances are you just saved yourself from getting sold out. If the market tone seems to deteriorate even more, you can sell it yourself after being relatively sure the bottom hasn't been found at the initial opening.
Now what? The stock got sold out after hitting your stop order. First, DO NOT chase it. Figure out what the problem is first. If it is just that the market tone is really nasty and everything is falling, let it fall. Don't try and guess the bottom. Eventually the market tone will firm and the stock will start back up. You will be able to buy it back then at that cheaper price if you really like it still. But if it is falling because it did something wrong, you need to be out any way. If it missed earnings or got sued or what have you, it could fall a long long way.
What do you do if it hits your stop order and sells you out and then pops back up another point? Here it gets tricky. Something brought it down that far in the first place so you have to determine what it was. Lets say it was the overall market tone, but now things are improving, do you buy it again? Here is where you are going to have to put all your thinking together. Was that the end? Is the market really healing or is it a fakeout?
We have found the safest way to determine it is like this: if WE thought something was good enough to own at $100 but we got stopped out at $95 during a bad market day, now that it is back to $96 is it any less attractive than at $100? Probably not. Again, we are talking about the overall market that was the culprit. We would probably buy it back (if we still liked it of course). But if we got stopped out while the overall market was doing fine, we wouldn't touch it again. The reason? Why did it fall the first time? There was something wrong.
"When
stocks are attractive, you buy them. Sure, they can go lower. I've bought
stocks at $12 that went to $2, but then they later went to $30. You just
don't know when you can find the bottom."
*-- Peter Lynch - One
Up On Wall Street
