The Art of the Stop Loss: Technical Primer

BALTIMORE (Stockpickr) -- The stop loss. Ask any active trader or investor what they think of stop losses, and you're bound to get a unique, passionate answer. Some market participants won't enter a trade without them, while others vow to never use a stop loss again.

Even if some investors decry stop losses, if used properly stops can be an incredibly effective tool to limit risk and increase the occurrence of profitable trades.

Today, we'll take a look at how to effectively use stop losses from a technical perspective.

First, though, let's take a look at exactly what a stop loss is. Stop losses, or stops, are sell orders that trigger if and only if a stock reaches a predetermined condition. That condition may be a set price, a set percentage decline, or a set absolute (dollar value) decline. They're used for one of two reasons: to avoid losing too much money (this is known as a protective stop), or to lock in gains.

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To fulfill that task, there are also a few different kinds of stop loss orders. The traditional stop loss order sends your broker a market order when it's triggered, whereas the stop-limit order not surprisingly sends a limit order. As you might expect, stop-limit orders can often secure you a better fill price on your stock -- but only when they get filled. For a stock that's quickly crashing, a market order may be your only option.

Another type of stop order is the trailing stop, which is used primarily to lock in gains. As your position increases in value, your trailing stop ratchets higher and higher -- but it only triggers if your percent-decline or dollar value decline conditions are met.

The Value of Stops for Technical Traders

It doesn't surprise me that stop losses are so controversial. For a fundamentals-only investor, stops can be downright terrifying. The oft-described stop loss nightmare comes from the fear that an investor will get stopped out only to see shares rocket in the ensuing weeks and months. Part of the problem is that fundamental investors can only base their stop loss levels on how much pain they're willing to take. If you're not willing to take more than a 10% hit on a stock, that's where you place your stop -- regardless of the market conditions.

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