This column was originally published on RealMoney on Oct. 20 at 11:19 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.
I receive more than my fair share of questions about stop-loss orders. How tight should they be? Should they be hard stops that trigger automatically, or should they be simple guidelines for reassessing the trade if the price falls? Since the professionals control the close, shouldn't stops be based on closing prices rather than intraday swings?
These are all valid questions, but as with most things related to trading, the answers are as unique as each trader asking the question. Let's take them in turn.
How tight should stops be? William O'Neil says 8%, though the great early 20th-century traders Gerald Loeb, Bernard Baruch and Jesse Livermore opted for the 10% rule. I'm not sure it makes much difference so long as the stop is always honored. The location of the stop really depends on where you are in the trade.
On my initial entry, I'd say that 8%-10% is the maximum allowable loss. Every time I have violated this rule, I have regretted it. If a stock moves against you and yet you do not sell it, you are asking the trade to do even more than you originally expected, because it must now retrace the post-entry decline and continue in the expected direction for an acceptable period of time. Better to simply close the trade immediately and wait for a better entry, or just move on.
Depending on your style, you may decide to close the trade long before your stop is hit. If the stock isn't acting like you expected, why wait until the pain gets worse?
Second, should the stops be set with automatic triggers, or should they be discretionary? This varies with the individual. For me, the answer is simple: automatic stops. I have a tendency to get emotional, and emotion clouds judgment. By drawing a line in the sand before the battle begins, I'm able to think the trade through carefully and determine the price point at which I'll know I'm wrong. If the stock hits that price, I'm out.
This style enables me to avoid the unpleasantness of deciding whether I'm really wrong or not -- when I have a vested interest in the outcome. I'd rather make those decisions before I'm so committed to the trade that I dread being wrong.
Last, should the stops be based on closing prices or intraday prices? I believe it's important to take all the trading action into account, not just the closing prices. The closing price is used to calculate most technical indicators, but a lot of trading takes place before that final print occurs.
It's difficult to know whether a stock that's in free fall during the day will abruptly turn around and close higher. Perhaps that free-falling stock will just continue to move lower. It's risky to stubbornly wait for the close before making a decision. Also, the idea is to choose a stop level at which you'll know you are wrong if the price hits it. It shouldn't matter when the stop is triggered.
Stop placement can be as easy or as complex as you allow it to be. But more important than the methodology you use for stop placement is the initial decision to actually
them, and the commitment to keep on using them. Do that, and you'll have a much better chance of succeeding as a trader.
Let's look at some readers' picks.
Last month, Mighty MO's multimonth uptrend ended on a high-volume selloff. I've circled the longest
price-by-volume bar, which marks the level at which the most trading occurred. As such, I'd expect a lot of latent buying interest if
falls back to $78.
With the stock just about to test the 50-day moving average at $80.50, it is at a crossroads. A move above would set the stage for a challenge to the August high. If it falls below $78, I'd suggest trying to kick this habit and moving on.
The obvious question about the
Energy Select Sector SPDR
is whether the current sideways action is simply consolidation that's a prelude to the next leg up or the makings of a top. Unfortunately, I don't have the answer.
I can only offer a couple of scenarios: If the ETF falls below $50, I'd stay far away from it; if it moves up to around $57.50, the bulls will probably run for a while. Until one of these two scenarios plays out, the SPDR is in jail.
has advanced more than 20% since the October low. Over the past few days, the stock has been trading within a $2.50 range. From the looks of Thursday's strength, I'd say that it's about to move out of this short consolidation period and begin an assault on the May high. But if the stock falls back below $65, I'd suggest closing this one out.
has been trading sideways for the past six months or so, which is the healthiest thing for this stock right now. We can see that it traded sideways in a similar fashion from October through March before moving up almost $30 over the next few months.
I'd wait for a sign that the stock is ready to move out of congestion. A push above the July high would signal the beginning of the next leg up; a fall below the recent low would signal that Garmin has lost its way.
I've highlighted the long price-by-volume bar on this chart of
to show how much trading volume has occurred at around $105. So long as the stock stays above that level, any pullback should attract those who sold at that level and are anxious to buy it back.
So far, we've got a series of higher highs and higher lows since early September. If Thursday's strength turns out to be the next low, then the uptrend is alive and well. If I were long, I'd keep a stop down around $100 or so. That's a long way down from the current price level, but this stock has been a bit volatile, so it's important to give it some room. Also, that long PBV bar runs clear down to around $103. Only when that support gives way could we make a case that the current uptrend has reversed.
Be careful out there.
At the time of publication, Fitzpatrick held none of the stocks mentioned, though positions may change at any time.
Fitzpatrick is a freelance writer and trading consultant who trades for his own account in Encinitas, Calif., and contributes to
. He is a former co-manager of a hedge fund and teaches seminars on technical analysis, options trading and asset-protection strategies for traders and business owners. Fitzpatrick graduated from the McGeorge School of Law and was a fellow at the Pacific Legal Foundation, a nonprofit public interest firm specializing in constitutional law. He also practiced law in the private sector before pursuing trading as a full-time career. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Fitzpatrick cannot provide investment advice or recommendations, he appreciates your feedback;
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