Six Steps to Better Stop Losses

Editor's Note: This column by Rob Martorana is a special bonus for TheStreet.com and RealMoney readers. It appeared on Street Insight on March 3. To sign up for Street Insight, where you can read Martorana's commentary in real time, please click here.

My obsession with stop losses began in 2002 when I was a portfolio manager at Barclays. We held Omnicom (OMC) for both our discretionary and advisory accounts, and one morning in June the stock began to sink.

It broke through key support levels while other media stocks were quiet, so our media analyst got on the phone. He discovered that a rumor of an accounting scandal was breaking, but it had not yet made it into the media. So some people knew and some people didn't. We recommended that our advisory accounts sell the shares immediately.

The stock fell 50% in three weeks, so we saved a lot of money for our clients who could act fast. This was a classic case in which the technical signal told you that "somebody knows something you don't." There was no fundamental sign of a problem and there wouldn't be until it was too late. The only reason we could act immediately was because we already had a stop loss in place.

This brings me to the old Wall Street cliché: "Cut your losses and let your winners run." Letting your winners run gets all the attention, but the ability to cut losses is one of the best measures of an investor. How do you handle it when the market goes against you? Are there stop losses in place to protect the portfolio? And are the stops set correctly? Although we all like to be right, we're competing against other investment professionals. Sometimes they know stuff that we don't, and sometimes they find out before we do.

Getting the Balance Right
This is where stop losses come in. Granted, setting stop losses properly takes some work up front, and it isn't always easy to get the balance right. If you set your stops too wide, you are subject to heavy losses. Yet setting your stops too narrow will get you whipsawed out of positions you should have kept.

Sure, you can always "buy it back later," but that means eating the spread and the commission costs. Even worse, the price may get away from you, causing you to miss the opportunity altogether. This means lost research time and fewer options for the portfolio. And most of us cannot afford to spend our time and research dollars on ideas that we don't execute correctly.