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Apprenticed Investor: Stop-Loss Breakdown

How can you avoid giving back all of your hard-won gains? I use the 25% net gains rule. Let's say you owned Amazon.com (AMZN - Get Report) in 2003, near $20. By the end of the year, the stock was above $60, giving you a 40-point gain. How do you preserve your profits if the stock reverses? Determine in advance how much of those profits you are willing to give back. I never like returning more than 25% to the house. When the stock reverses enough so that 25% of those gains have slipped away, that's your sell signal. In the Amazon example, that was a 10-point move down to $51. That's my liquidation point.

The goal of this stop loss is simple: Give the stock enough room to trade, but do not give back all of your profits.

  • Time Stop: Stocks not only go up and down, they also can just go sideways. While this is not a dollar loss, it is a loss of a different kind. Tying up capital in a stock that's doing nothing involves opportunity costs. It means that your capital is not in another investment making money for you.
  • If you buy a stock at $17, and all it does is fluctuate between $15 and $20 for the next 10 years, there's probably a better place to deploy your capital. You can always come back to the name and buy in when it finally breaks out over $20.

    When you purchase a security, decide in advance how long you are willing to hold it. Give it enough time for catalysts to develop. Six months to a year should be sufficient. The market is far less efficient than many people -- especially academics -- assume. If your stock is really undervalued, the rest of the world will eventually figure it out.

    What you don't want to do is sell something out of boredom. Too often, this seems to happen just before a stock takes off.

    In Conclusion

    There's a reason flight attendants show you where the emergency exits are before takeoff. The same thinking should apply to investors. Prudent investors have a sell strategy in place before they get involved with a stock. Using any of these stop strategies helps keep your emotions out of the process when an investing emergency arises.



    1. Expect to Be Wrong 2. Your Fault, Reader
    3. The Wrong Crowd 4. Bull or Bear? Neither
    5. Know Thyself 6. Prepare for Battle
    7. Bite Your Tongue 8. Don't Speak, Part 2
    9. The Zen of Trading 10. The Folly of Forecasting
    11. Lose the News 12. Tracking Elephants, Pt 1
    13. Tracking Elephants, Pt 2 14. Nothing Doing
    15. Surviving Silly Season 16. The Zen of Trading
    17. Curb Your Enthusiasm 18. Six Stocks
    19. Bended Knee 20. Time Waits for No One
    21. Write this Down 22. Trading Diary, Part II
    23. Protect Your Backside
    Check back for more of Barry Ritholtz's
    Apprenticed Investor series

    Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback; click here to send him an email.

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