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 TheStreet.com 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

In looking at the chart, it's clear that the risk profiles of P&G and Baidu are very different, so assigning the same risk profile to them makes no sense. It could be argued that a 5% decline in P&G would be more of a reason to worry than a 10% decline in Baidu.

Put the Decline in Context

The reason for the decline should also play a role in how a stop order is used. I tend to be less worried about a stock that drops 9% if the broad market is dropping 8% at the same time. A 9% drop would be more of a concern in a flat market or a rising market -- but then again, maybe not.

Gold mining stocks often zig when the market zags. If you own a gold miner for that reason and it, along with all the miners, is going down in an up market, should you really sell it? In that scenario, it's doing its job.

If you believe in maintaining a diversified portfolio and if a stock you own in a sector is down an amount consistent with the rest of its sector, it probably shouldn't be sold on the basis of an arbitrary price movement.

Poor Timing

Another problem with arbitrarily using the same percentage decline for all stop orders is the chance that the 8% decline represents the bottom of the move. If you use stop orders a lot, you have been stopped out at a low. This just goes with the territory, but consider that it also causes more trades, thus costing you not only a potential profit but a definite broker's commission.

Picking where a decline bottoms out is in part guesswork. Depending on your ability to read a stock chart, you may be making only a very educated guess. But every decline has a bottom, and someone always winds up selling at that bottom tick.

Stock-Picking

The last problem I see with stop orders is the stock selection aspect. At some point in your stock-picking process, you had to decide which stock of say, two was the better choice.

So if the "better choice" goes down 8%, are you automatically going to buy what you previously thought was second-best? I sure hope not; remember, you've got to check your first-choice stock's risk profile, put its decline in context and be aware of the possibility that it's at bottom.

Tailor Your Strategy

I'm not saying that stop orders should be avoided; quite the opposite. Stop orders can be very useful, if you understand the limitations of this type of exit strategy and don't use them in an arbitrary manner.

I am all for having exit strategies. Just tailor each exit strategy to the specifics of each stock; a utility stock should have a different exit strategy from a biotech stock.

Also, know the reason you want to sell each stock you hold; that should be factored in to your process. For example, if you buy a stock because it is a proxy for a foreign country but it fails to correlate with that country, you probably want to sell. Or if you want a brokerage stock, you go through the process of narrowing down the field of possibilities to what you believe is the better choice. If your first choice proves wrong (and you've of course determined during your selection process what would make it "wrong"), it behooves you to sell and switch to your "second choice," or even to switch sectors.

The possibilities are endless. If you're going to manage your own portfolio, you need to be willing to adapt the manner in which you take defensive action.

This column was originally published on RealMoney on July 27, 2007 at 11:30 a.m. ET. For more information about subscribing to RealMoney, please click here.

At the time of publication, Nusbaum had no positions in any of the stocks mentioned in this column, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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