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Apprenticed Investor: Stop-Loss Breakdown

On the other hand, buying a stock right above support, with a stop just below, offers good risk/reward potential. Downside is limited to a few points, while upside may be substantial.

  • Stop Below Moving Average: One of the most reliable sell signals is the 50- or 200-day moving average (MA). The MA is the average daily closing price of a stock for a specific number of days.
  • When a stock is rising, its moving average will rise, albeit at a lag. Once the stock begins to falter, its price will fall much faster than the moving average. When the share price crosses the average to the downside, that's a very powerful sell signal.

    Since the market peaked in March 2000, every major disaster -- from Lucent (LU) to Global Crossing to WorldCom -- has given clear 200-day moving average sell signals.

  • Trailing Stops: Any of the above stop losses can be turned into a "trailing stop." This strategy locks in specific profits and prevents you from giving back too much of a winning position.
  • Regardless of what your original stop loss was, you should raise it as a position rises. Each time your stock enters a new "decade" ($30s, $40s, $50s, $60s, etc.), you increase your stop loss proportionately. You can adjust the stop loss on the basis of the weekly or even monthly closing prices. This makes it more likely you'll get the benefit of a rising stock price for as long as possible, while still getting downside protection.

    When moving your stops up, it's a good idea to avoid using round numbers (i.e., $60, $70, $80), because option strike prices can temporarily "pin" a stock to those levels on expiration day each month. There's a tendency for stocks to trade to just below these levels and then snap back. For lower-priced stocks (say, under $20), try using weekly increments of $5 instead of "decades."

  • Profit Protection Stop Loss: One frustrating issue for investors is when a winning position starts reversing on them. Those profits that took so long to accumulate slowly start slipping away.
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