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.

Stop losses are also a great portfolio-management tool because of the discipline they force on the investor. An effective stop-loss process forces you to evaluate both the upside and the downside before money is invested, and it forces you to commit to a specific time horizon. This is why stop losses merit your time and energy. While I don't claim to be the last word in setting stop losses, I've been a stock analyst and money manager for 20 years. And as the director of content of Street Insight, I work with dozens of money managers who have a wide variety of investment styles.

Yet it has been my exposure to technical analysis, however superficial, that has been most useful to setting my stop-loss levels. I believe that the process must integrate technical and fundamental analysis to be effective. Some would call this behavioral finance, but I'll spare you the lecture on regret aversion, hindsight bias and my personal favorite, "magical thinking." I like magic as much as the next guy, but there's no need to dress up common-sense investing as a secret statistical priesthood.

Putting It All Together
All of this sounds like a lot of work. But the example below is only a few lines long, and it comes from someone who sets stop losses effectively: Street Insight contributor Mark Thomas. This is from a recent The Long/Short Investor article in which he discusses his bullish views on CSX Corp. (CSX).

I think the stock could be worth $60 within six to nine months. I like the fact that the stock here at $54.40 has a potential upside of almost $6, with a potential downside of $3 (or a 2-to-1 reward-to-risk ratio). My stop loss is set at $51.40, the stock's low this February.

Now this doesn't exactly set the house on fire. Mark is not pounding the table, and he's only looking for about 10% upside. But CSX is a liquid stock with a low-risk profile, and the time horizon is well under a year. This is a well-defined trade with a stop loss that makes sense. So a 2-to-1 ratio of reward-to-risk is fine, and it is very clearly explained.

Work like Mark's reflects a lot of hard-won experience and a disciplined investment process. I've tried to boil this down into six simple steps that apply to traders and investors of every stripe, though I focus on stock investing. So, what are the six steps to an effective stop-loss process? Let's begin with the obvious.


Step 1: Do Your Work Before You Lay Your Money Down
Even the greatest investors can get emotional when their positions are under fire. The best defense is preparation: Define your stop before you put your money on the table. Once we have skin in the game, we are all tempted to rationalize. That is the primary benefit of trading stops -- they save us from our own foolishness.

Whatever your process, I cannot emphasize enough the importance of doing your stop-loss work before you invest. Afterward, you are in the midst of battle, and the fog of war creeps in. You are distracted, off balance and prone to emotional errors. Your idea has failed and you feel rotten. This can only be fought with preparation and discipline.

One investor with rigorous stop-loss discipline is Street Insight contributor Ed Stavetski. Yet his process is very simple: Ed uses an 8% stop loss for all short positions and a 10% stop loss for his long positions. No exceptions.

This discipline saved Ed's clients from losses last fall in Pacific Sunwear of California (PSUN). Ed had shorted the stock last summer because the apparel retailer was a step behind in fashion trends. But the stock rallied last fall and Ed's PSUN position got stopped out at an 8% loss. But the portfolio would have suffered twice this loss if Ed had held on to PSUN for another few weeks. This retail stock may yet crash, but short investors don't have time on their side. So it pays to keep a tight rein on short ideas.

Because this approach is so simple, it can be applied rapidly to a large portfolio, or to a high-velocity trading strategy. Simpler is faster. Simpler is better when time is of the essence, or when dealing with multiple positions. Other types of investors can enhance returns, though, with a little more work. This brings us to Step 2: Know Thyself.

For my video clip of Step 1, please click here.


Step 2: Determine Your Investment Style
Your investment style will determine how complex your stop-loss process should be. You may be a rapid-fire technical trader with a lot of high-risk positions. Or you may be a conservative long-term fundamental analyst with a concentrated portfolio. Either way, your investment style will determine what your stop-loss process should be. You must know this before you begin. Your time frame, trading frequency, risk tolerance and even your conviction in your ideas are all considerations in establishing effective stops.

While there is no foolproof method for setting stops, these factors are your primary considerations. These will go a long way toward establishing the general width of your stop losses and your time horizon (or the "expiration date," discussed in Step 3). Numerous positions and high portfolio turnover argue for simple stop-loss levels, while a concentrated, long-term portfolio allows for more sophisticated methods. And your risk tolerance and conviction in your ideas will determine how much room to give to positions where the technicals and fundamentals give conflicting signals.

Another issue to consider is whether you are investing for absolute or relative returns. Lots of stock investors say they aim for absolute returns. They want to make money regardless of the market's direction. Yet they refuse to predict the direction of the market. If you are truly an absolute return investor in stocks, you must have an opinion on the direction, magnitude and timing of the overall equity market. Otherwise, you risk the classic mistake of thinking, "Well, the stock is off but so is the market. So my stop loss isn't relevant."

No. The answer is that you didn't set your stop loss correctly. Or maybe you just don't know what your goal is. I think that you've been kidding yourself about your commitment to absolute returns. What you really want is to outperform the equity market.

This is fine. For the majority of people, exposure to equities is more important than tactical asset allocation. But if you are investing for relative returns, your stop-loss process needs to reflect this. You need to rely on the stock's performance relative to the market and relative to industry peers. These are more relevant than absolute support and resistance levels, though I still think that these are important. The key is to determine how much variance you can tolerate. A little variance from the market and from peers is to be expected. But when a significant trend emerges, it's time to cash out. I'll discuss this in more detail below, but let's not get ahead of ourselves. Don't assume that the price chart is your only tool.

For my video clip of Step 2, please click here.


Step 3: Establish a Clear Time Frame
There is more to stop losses than price; there is time. Milk has an expiration date because it will eventually go sour. Likewise, even the best investment ideas sometimes get stale and begin to head south. You want to eliminate stale ideas.

Bullish investors often delude themselves when they say, "The stock is down, but this is a long-term investment." That type of thinking is for fools. Stocks drop for a reason, and a major drop has a major reason. If you have set your stop loss correctly, you've given the idea enough room to breathe. So you shouldn't get stopped out because of normal volatility.

Don't get me wrong. There is nothing wrong with having a five-year time horizon, a 10-year time horizon or any time horizon your heart desires. But a long-term horizon is no excuse for falling asleep at the wheel.

In any case, there comes a time when even the best rationales become broken. Things just didn't play out as you expected. Maybe you thought lower energy prices would boost your airline stock. Then oil prices fell and the stock just sat there. (Hint: Oil falls when the economy slows, which ain't the best time for vacation and business travel.) Whatever the reason, it just didn't work out. So even though your idea didn't get torpedoed by a risk you anticipated, your position is now unprofitable.

In this case, the point of a stop loss is simply to protect your portfolio. You do not want to spend your time reevaluating all of the possibilities and revising your price target. This leads to the notorious rationalization, "Yeah, the news was bearish, but now it's in the stock." This is how good ideas go bad -- they get stale, turn sour and begin to smell funny. So your ideas need to have expiration dates, just like a carton of milk.

For my video clip of Step 3, please click here.


Step 4: Listen to What the Chart Tells You
Assuming that your investment rationale has some fundamental analysis and an explicit time frame, the next step is to look at the relevant trading history of the stock. This includes both the stock's volatility and key support/resistance levels. First, let's consider volatility.

A stop loss needs to give a security enough room for the investment thesis to play out over the time frame you expect. So a stop loss for a volatile security is going to be wider than a stop loss for a stable security. Intel (INTC) is more volatile than Johnson & Johnson (JNJ), so Intel will have a wider stop loss than JNJ for any given time frame. (Intel should also have a better risk/reward ratio, or you're taking on risk without a reward.)

In addition to volatility, a stock's major support and resistance levels are also important. I cannot tell you how irritating it is to read a bullish recommendation that uses a price target $1 above an all-time high. The stock analyst simply took an industry P/E and multiplied it by forward EPS, and voila! We have a price target. But if a stock has not traded above $43.50 for five years, it's just plain stupid to use a price target of $44. This is completely out of touch with reality.

I'll be the first to admit that I am not a specialist in technical analysis. But anyone who has traded or invested for more than a month knows that stocks keep on running when they break major resistance levels. If it wasn't major news, the stock wouldn't have broken out! Likewise, a long-standing support level won't simply fail unless the stock is in major-league trouble. This isn't technical analysis; it's just common sense.

What is a "significant" support or resistance level? Generally speaking, the longer the price has stayed in a range, the more robust the support and resistance levels are. You also want to make sure that you are looking at a price history that matches your own time horizon. Finally, you want to consider the magnitude of the catalyst you expect.

For example, if you expect the idea to play out during the next three months, then the last three months of trading activity are the most relevant. You might want to go back a little longer if there is a major move in the stock, but this is a good place to start. As for the catalyst, it takes a major catalyst to break major resistance. So don't look for the stock to hit an all-time high if the firm beats earnings by a penny.

Ideally, you should use this same rigor when looking at volume. Surging volume or sagging volume is its own signal of investor interest. High volume confirms price moves, and low volume confirms consolidation periods. (Stocks get less attention from investors during consolidation periods, so volume is usually lower.) But before you make your process too complicated, be realistic. Make sure that you understand how much time your investment style allows you to devote to the stop-loss process. You may not be able to consider volume unless the signal is exceptional. And since I believe that volume signals are secondary to price signals, you should allocate your time accordingly.

For my video clip of Step 4, please click here.


Step 5: Execute
A stop loss is useless unless you put it into action. Executing the stop means liquidating the position. This is not a time to "review" the position. Good investors are always reviewing their positions. But when your position is busted, it's simply time to fold your hand and move on.

If you want to set a stop that gives you a warning, that's fine. Maybe you have a big portfolio and a lot of ground to cover. So maybe you want to trim the position if it hits your stop. But this is not what most people consider when they are talking about a stop loss. A 'hard' stop loss automatically liquidates the position. A 'soft' stop loss, meanwhile, involves trimming the position, a full-blown review of it or other action you may determine.

Personally, I don't recommend soft stops. The entire point of stop losses is to identify and eliminate losing trades, so I believe in hard stops. That is, once the stop is set, you automatically close out the position when the market goes against you.

Nevertheless, there are times when soft stops can work. The following is an example of a soft stop used by a long-term value investor, Street Insight contributor Tom Au. This excerpt discusses his short idea in the restaurant chain P.F. Chang's China Bistro (PFCB), which recently traded at $48.60.

I am looking for PFCB to decline to the low $30s. As for the time horizon, I'd be looking for an intermediate drop to about $40 in a six-to-12-month time period, and a longer-term drop to the low $30s when the stock (and the market) fully corrects.
I consider it significant that the stock tried and failed to break out into the mid-$50s on high volume after its earnings release. As for a buy stop, I am using a soft stop at about $55. This is about 10% above the recent quote, and I note that the stock has shown heavy resistance at $55.

Tom has a soft stop at $55, which is near heavy resistance for the stock. It's a good idea to cover since the stock could run away from him if it breaks through this level. With the stock recently trading at $48.60, the risk/reward profile is less than 2 to 1 in the near term. But this is OK because Tom thinks the idea has a lot more upside potential as time goes on.

Another variation of a soft-stop loss is "sell half and decide later." When the security violates your stop loss, you sell half the position immediately. This reduces risk and allows you to be more objective. You have half the risk, so you are more likely to think clearly. And you have more time, since the portfolio is not fully exposed to the position. You may still exit the position, but now you have time to think.

Whatever you decide, execution should be automatic. Investing is a percentage game and experience shows that proper stop losses boost your returns. Nevertheless, no rule covers every situation.

For my video clip of Step 5, please click here.


Step 6: Remember, Trading Gaps Are the Exception to the Rule
Sometimes a stock will gap higher or lower, making your stop-loss level irrelevant. Sometimes a stock will open 15% below the prior day's close and below your stop-loss level. Should you still sell?

My experience has shown that this is the one time when you should break the rules: Do not liquidate the position immediately .

Trading gaps are the one time when even the best stop-loss strategies do not add value. When a security blows through a stop-loss level, it is usually because major news causes the stock to "gap" up or down, or because the entire market has hit an air pocket. A stop loss is powerless against this and this is one of the reasons that portfolio insurance was ineffective during the crash of 1987.

The only way to protect your portfolio against this is to buy out-of-the-money options. This is how hedge-fund manager Doug Kass often protects his positions, since it is a cost-effective way to hedge his portfolio. Fellow Street Insight contributor Scott Rothbort is also a frequent user of options to supplement his stock positions and hedge his portfolio.

If you are hedging against an event that is highly unlikely, the options shouldn't be too expensive. That's the whole point: Your stop-loss should give the stock enough room for normal volatility, so your up-front cost for the options should be reasonable. If you're comfortable trading options, this is a great tactical tool for your stop-loss strategies.

But if your position is unhedged, what do you do? Say you are trading biotech stocks, which have enormous volatility. These stocks do not trend. The charts are random, with spikes and crashes that come without warning from fundamental or technical signals. Trading gaps in biotech stocks are often caused by announcements from the FDA about new drugs. This volatility is something that none of us can predict. (If you know what the FDA is going to say before the public does, I don't want to hear about it.) Fortunately, there is a way to deal with trading gaps: Reset the clock.

After studying the performance of a wide variety of health care stocks, Street View analyst Mike Latwis and I have learned that you should not automatically close a position after it gaps up or down. Instead, you need to reassess the position. We have found that a gap in the stock price is often an overreaction, and a trading spike often reverses itself. Even when it doesn't, the stock usually has a period of consolidation, which allows you to exit at a reasonable price. Because of this, the stop loss now has only a 50/50 chance of being effective.

So the best course of action is to reset the clock and start over. You now need to determine a new price target, time frame, and stop-loss level. And this time the position should be automatically liquidated if the stock trades through the stop loss. You should liquidate because the stock's price action has confirmed the original trend. This market has gone against you and you need to move on.

For my video clip of Step 6, please click here.

Feedback Welcome
Setting a stop loss seems like a lot of work, but it is a discipline that will boost your investment returns. So start out slowly with some simple rules of thumb. Even this is better than nothing, and you can always work up to a full-blown process once you find out what feels right to you.

I hope you've found this helpful and I welcome your feedback. Shoot me an email with your thoughts.

Robert Martorana is the director of content, TSC Professional Products. Robert brings 19 years of Wall Street experience to the position, and was most recently a portfolio manager and head of U.S. equity research at Barclays. Prior to 1996, Robert managed small-cap stocks at Schroder Capital Management International, with a focus on energy, basic materials, and capital goods. He was also an equity analyst at Vontobel USA and was an editor and senior industry analyst for The Value Line Investment Survey.

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