There's an old joke about the investor who never used any stop losses. His friend knew his big positions were getting crushed.

Out of concern, the friend asked, "How are you sleeping?"

"Like a baby" he answered.

"Really? You aren't nervous or upset?"

"I sleep like a baby" he repeated.

"That's amazing. I'd never be able to sleep through the night with those types of losses."

"Who said anything about sleeping through the night? I said I slept like a baby: I wake up every two hours, wet myself and cry for 30 minutes before falling back to sleep."

That's why risk management is so critical: to save you from sleeping like a baby, and in the long run to save you a lot of money.

Last week's column focused on protecting your assets and avoiding "fiasco" stocks. The method we discussed was the simplest of all stop losses: the percentage stop.

The percentage stop is not my favorite type of stop loss, but it is better than none at all.

The tricky part is deciding what percentage to use. Make the stop too tight (i.e., 6% to 8%), and in a volatile market you will get stopped out constantly. If the stop loss is too broad (i.e., 25%), then by the time it gets triggered, a lot of damage is already done.

I prefer percentage stops between 12% and 15%; longer-term holders and volatile tech stocks may need a little more room to oscillate. Your goal is to protect yourself against a position that's gone sour -- not against ordinary short-term market swings.

This week, we review several other stop-loss strategies you can use to prevent losses from getting out of hand.

All Kinds of Stops

  • Stops Below an Uptrend: Placing a stop just below an uptrend is a technically based loss limit. The goal is to liquidate a position that is in the early stages of institutional distribution (i.e., mutual fund selling).
  • Use a daily or weekly chart, draw a line connecting the three most recent lows. On the far right side of the chart, place a mark a short way below that line. That's your stop loss.

    Don't Fight the Trend
    When Cisco broke its long uptrend in mid-2000, it was time to bail on John Chambers & Co.
    Source: Barry Ritholtz

    This stop should be monitored as the stock price rises. Review it at least once a month; active traders review their stops more often, typically weekly (or even daily).

    I know traders who like to re-enter a position after getting stopped out if it reverses back above the trend line. For example, when Apple's ( AAPL) trendline broke at $38, it looked as though the institutional world was in the early stages of major distribution in Apple. Once the stock returned to that trendline, we knew that was not true. It's worth occasionally missing a few points to avoid riding a profitable position back down to break-even or worse.

    Bruised, Not Rotten
    Apple's trend break last spring was a false signal
    Source: Barry Ritholtz

  • Stop Loss Below Support: You don't have to be a technician to see where support is on a chart. Look for the horizontal line that a stock often trades down to, then bounces off. That line reflects the price where buyers find the stock compellingly cheap. It's also where they have reliably bought it in the past. Support often holds, because investors remember the last time that stock was that cheap and they failed to buy. That memory of missed opportunity is what supports the stock from falling further; your stop loss goes a little below that level.
  • Retailer on Sale
    Wal-Mart's break of long-term support was a sell signal
    Source: Barry Ritholtz

    When a stock breaks support, it suggests that the thinking about the company may have changed. Perhaps the company's prospects are no longer so rosy and the stock no longer looks cheap at that price.

    Whatever the reason, a break in support often precedes a further move south.

    On the other hand, buying a stock right above support, with a stop just below, offers good risk/reward potential. Downside is limited to a few points, while upside may be substantial.

  • Stop Below Moving Average: One of the most reliable sell signals is the 50- or 200-day moving average (MA). The MA is the average daily closing price of a stock for a specific number of days.
  • When a stock is rising, its moving average will rise, albeit at a lag. Once the stock begins to falter, its price will fall much faster than the moving average. When the share price crosses the average to the downside, that's a very powerful sell signal.

    Since the market peaked in March 2000, every major disaster -- from Lucent ( LU) to Global Crossing to WorldCom -- has given clear 200-day moving average sell signals.

  • Trailing Stops: Any of the above stop losses can be turned into a "trailing stop." This strategy locks in specific profits and prevents you from giving back too much of a winning position.
  • Regardless of what your original stop loss was, you should raise it as a position rises. Each time your stock enters a new "decade" ($30s, $40s, $50s, $60s, etc.), you increase your stop loss proportionately. You can adjust the stop loss on the basis of the weekly or even monthly closing prices. This makes it more likely you'll get the benefit of a rising stock price for as long as possible, while still getting downside protection.

    When moving your stops up, it's a good idea to avoid using round numbers (i.e., $60, $70, $80), because option strike prices can temporarily "pin" a stock to those levels on expiration day each month. There's a tendency for stocks to trade to just below these levels and then snap back. For lower-priced stocks (say, under $20), try using weekly increments of $5 instead of "decades."

  • Profit Protection Stop Loss: One frustrating issue for investors is when a winning position starts reversing on them. Those profits that took so long to accumulate slowly start slipping away.
  • How can you avoid giving back all of your hard-won gains? I use the 25% net gains rule. Let's say you owned Amazon.com ( AMZN) in 2003, near $20. By the end of the year, the stock was above $60, giving you a 40-point gain. How do you preserve your profits if the stock reverses? Determine in advance how much of those profits you are willing to give back. I never like returning more than 25% to the house. When the stock reverses enough so that 25% of those gains have slipped away, that's your sell signal. In the Amazon example, that was a 10-point move down to $51. That's my liquidation point.

    The goal of this stop loss is simple: Give the stock enough room to trade, but do not give back all of your profits.

  • Time Stop: Stocks not only go up and down, they also can just go sideways. While this is not a dollar loss, it is a loss of a different kind. Tying up capital in a stock that's doing nothing involves opportunity costs. It means that your capital is not in another investment making money for you.
  • If you buy a stock at $17, and all it does is fluctuate between $15 and $20 for the next 10 years, there's probably a better place to deploy your capital. You can always come back to the name and buy in when it finally breaks out over $20.

    When you purchase a security, decide in advance how long you are willing to hold it. Give it enough time for catalysts to develop. Six months to a year should be sufficient. The market is far less efficient than many people -- especially academics -- assume. If your stock is really undervalued, the rest of the world will eventually figure it out.

    What you don't want to do is sell something out of boredom. Too often, this seems to happen just before a stock takes off.

    In Conclusion

    There's a reason flight attendants show you where the emergency exits are before takeoff. The same thinking should apply to investors. Prudent investors have a sell strategy in place before they get involved with a stock. Using any of these stop strategies helps keep your emotions out of the process when an investing emergency arises.

    1. Expect to Be Wrong 2. Your Fault, Reader
    3. The Wrong Crowd 4. Bull or Bear? Neither
    5. Know Thyself 6. Prepare for Battle
    7. Bite Your Tongue 8. Don't Speak, Part 2
    9. The Zen of Trading 10. The Folly of Forecasting
    11. Lose the News 12. Tracking Elephants, Pt 1
    13. Tracking Elephants, Pt 2 14. Nothing Doing
    15. Surviving Silly Season 16. The Zen of Trading
    17. Curb Your Enthusiasm 18. Six Stocks
    19. Bended Knee 20. Time Waits for No One
    21. Write this Down 22. Trading Diary, Part II
    23. Protect Your Backside
    Check back for more of Barry Ritholtz's
    Apprenticed Investor series
    Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback; click here to send him an email.

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