Apprenticed Investor: Stop-Loss Breakdown

There's an old joke about the investor who never used any stop losses. His friend knew his big positions were getting crushed.

Out of concern, the friend asked, "How are you sleeping?"

"Like a baby" he answered.

"Really? You aren't nervous or upset?"

"I sleep like a baby" he repeated.

"That's amazing. I'd never be able to sleep through the night with those types of losses."

"Who said anything about sleeping through the night? I said I slept like a baby: I wake up every two hours, wet myself and cry for 30 minutes before falling back to sleep."

That's why risk management is so critical: to save you from sleeping like a baby, and in the long run to save you a lot of money.

Last week's column focused on protecting your assets and avoiding "fiasco" stocks. The method we discussed was the simplest of all stop losses: the percentage stop.

The percentage stop is not my favorite type of stop loss, but it is better than none at all.

The tricky part is deciding what percentage to use. Make the stop too tight (i.e., 6% to 8%), and in a volatile market you will get stopped out constantly. If the stop loss is too broad (i.e., 25%), then by the time it gets triggered, a lot of damage is already done.

I prefer percentage stops between 12% and 15%; longer-term holders and volatile tech stocks may need a little more room to oscillate. Your goal is to protect yourself against a position that's gone sour -- not against ordinary short-term market swings.

This week, we review several other stop-loss strategies you can use to prevent losses from getting out of hand.

All Kinds of Stops

Stops Below an Uptrend: Placing a stop just below an uptrend is a technically based loss limit. The goal is to liquidate a position that is in the early stages of institutional distribution (i.e., mutual fund selling).

Use a daily or weekly chart, draw a line connecting the three most recent lows. On the far right side of the chart, place a mark a short way below that line. That's your stop loss.

Don't Fight the Trend When Cisco broke its long uptrend in mid-2000, it was time to bail on John Chambers & Co.

Source: Barry Ritholtz

This stop should be monitored as the stock price rises. Review it at least once a month; active traders review their stops more often, typically weekly (or even daily).

I know traders who like to re-enter a position after getting stopped out if it reverses back above the trend line. For example, when Apple's (AAPL - Cramer's Take - Stockpickr) trendline broke at $38, it looked as though the institutional world was in the early stages of major distribution in Apple. Once the stock returned to that trendline, we knew that was not true. It's worth occasionally missing a few points to avoid riding a profitable position back down to break-even or worse.

Bruised, Not Rotten Apple's trend break last spring was a false signal

Source: Barry Ritholtz

Stop Loss Below Support: You don't have to be a technician to see where support is on a chart. Look for the horizontal line that a stock often trades down to, then bounces off. That line reflects the price where buyers find the stock compellingly cheap. It's also where they have reliably bought it in the past. Support often holds, because investors remember the last time that stock was that cheap and they failed to buy. That memory of missed opportunity is what supports the stock from falling further; your stop loss goes a little below that level.

Retailer on Sale Wal-Mart's break of long-term support was a sell signal

Source: Barry Ritholtz

When a stock breaks support, it suggests that the thinking about the company may have changed. Perhaps the company's prospects are no longer so rosy and the stock no longer looks cheap at that price.

Whatever the reason, a break in support often precedes a further move south.