Six Steps to Better Stop Losses

Work like Mark's reflects a lot of hard-won experience and a disciplined investment process. I've tried to boil this down into six simple steps that apply to traders and investors of every stripe, though I focus on stock investing. So, what are the six steps to an effective stop-loss process? Let's begin with the obvious.

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Step 1: Do Your Work Before You Lay Your Money Down
Even the greatest investors can get emotional when their positions are under fire. The best defense is preparation: Define your stop before you put your money on the table. Once we have skin in the game, we are all tempted to rationalize. That is the primary benefit of trading stops -- they save us from our own foolishness.

Whatever your process, I cannot emphasize enough the importance of doing your stop-loss work before you invest. Afterward, you are in the midst of battle, and the fog of war creeps in. You are distracted, off balance and prone to emotional errors. Your idea has failed and you feel rotten. This can only be fought with preparation and discipline.

One investor with rigorous stop-loss discipline is Street Insight contributor Ed Stavetski. Yet his process is very simple: Ed uses an 8% stop loss for all short positions and a 10% stop loss for his long positions. No exceptions.

This discipline saved Ed's clients from losses last fall in Pacific Sunwear of California (PSUN). Ed had shorted the stock last summer because the apparel retailer was a step behind in fashion trends. But the stock rallied last fall and Ed's PSUN position got stopped out at an 8% loss. But the portfolio would have suffered twice this loss if Ed had held on to PSUN for another few weeks. This retail stock may yet crash, but short investors don't have time on their side. So it pays to keep a tight rein on short ideas.