Stop and Think Before Using Stop Losses

In looking at the chart, it's clear that the risk profiles of P&G and Baidu are very different, so assigning the same risk profile to them makes no sense. It could be argued that a 5% decline in P&G would be more of a reason to worry than a 10% decline in Baidu.

Put the Decline in Context

The reason for the decline should also play a role in how a stop order is used. I tend to be less worried about a stock that drops 9% if the broad market is dropping 8% at the same time. A 9% drop would be more of a concern in a flat market or a rising market -- but then again, maybe not.

Gold mining stocks often zig when the market zags. If you own a gold miner for that reason and it, along with all the miners, is going down in an up market, should you really sell it? In that scenario, it's doing its job.

If you believe in maintaining a diversified portfolio and if a stock you own in a sector is down an amount consistent with the rest of its sector, it probably shouldn't be sold on the basis of an arbitrary price movement.

Poor Timing

Another problem with arbitrarily using the same percentage decline for all stop orders is the chance that the 8% decline represents the bottom of the move. If you use stop orders a lot, you have been stopped out at a low. This just goes with the territory, but consider that it also causes more trades, thus costing you not only a potential profit but a definite broker's commission.

Picking where a decline bottoms out is in part guesswork. Depending on your ability to read a stock chart, you may be making only a very educated guess. But every decline has a bottom, and someone always winds up selling at that bottom tick.

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At the time of publication, Nusbaum had no positions in any of the stocks mentioned in this column, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.