How can you avoid giving back all of your hard-won gains? I use the 25% net gains rule. Let's say you owned
(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
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.
There's a reason flight attendants show you where the emergency exits are
takeoff. The same thinking should apply to investors. Prudent investors have a sell strategy in place
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.