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
Different Risk Profiles, Different StopsIn 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|
Put the Decline in ContextThe 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 TimingAnother 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.