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Stop and Think Before Using Stop Losses

This column was originally published on RealMoney on July 27, 2007 at 11:30 a.m. ET. It's being republished as a bonus for University readers. For more information about subscribing to RealMoney, please click here .

We need to talk exit strategies. Specifically, a reader asked what I think about using stop orders as the market has started to -- well, I don't know if it is cracking or is now simply more volatile than it has been over the last couple of years. Either way, you need to understand how to use these well, instead of simply defaulting to a one-size-fits-all strategy that won't help you beat any benchmarks.

A stop order is simply a tool that market participants can use to take defensive action. In the case of a long position, it tells your broker that once a stock hits the price you name, you want to sell at the market price . For short positions , it's set to make a buy at market price once a stock climbs to the price you specify.

Like all tools available to investors, stop orders have plusses and minuses. Understand them and you can use this tool to protect yourself when a position goes against you -- a common malaise right now.

A common strategy for placing stop orders is simply to put one 8% below your purchase price. This has never made sense to me for several reasons. I advocate for tailoring your stop order to your stock, for reasons I'll make clear as I review why using this rule of thumb is more like hitting your thumb with a hammer.

Different Risk Profiles, Different Stops

In applying this logic, you are saying that a stock such as Procter & Gamble (PG) has the same risk profile as, say, Baidu (BIDU). That's surely not the case.

An 8% decline in Baidu would be much different from a similar drop in P&G. Declines of that magnitude happen quite routinely with Baidu -- and much larger, actually -- but rarely happen for P&G.

Because 8% declines happen so frequently with Baidu, 8% is too tight a stop; you'd get stopped out of the position soon after entry, and possibly before your entry point had time to pay off. If a 2% decline in P&G is not a worry, and something that small shouldn't be, perhaps a 10% decline in Baidu shouldn't be a worry, either.

A Hazard in Risk
P&G's risk profile isn't the same as Baidu's
Click here for larger image.
Source: Yahoo! Finance

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