How to Use a Stop Loss: Technical Analysis Primer

BALTIMORE (Stockpickr) -- Do you use stop losses -- and more important, do you use them correctly?

Effective stops can be a trader's best friend, but improperly used, they can be your worst nightmare.

Ask any active trader or investor what they think of stop losses, and you're bound to get a unique, passionate answer. Some market participants won't enter a trade without them, while others vow to never use a stop loss again. Even though some investors decry stop losses, if used properly they can be an incredibly effective tool to limit risk and increase the occurrence of profitable trades.

Today we’ll take a look at how to effectively use stop losses from a technical perspective.

First, though, let’s take a look at exactly what a stop loss is. Stop losses, or stops, are sell orders that trigger if and only if a stock reaches a predetermined condition. That condition may be a set price, a set percentage decline, or a set absolute (dollar value) decline. They're used for one of two reasons: to avoid losing too much money (this is known as a protective stop) or to lock in gains.

To fulfill that task, there are also a few different kinds of stop loss orders. The traditional stop loss order sends your broker a market order when it's triggered, whereas the stop-limit order not surprisingly sends a limit order. As you might expect, stop-limit orders can often secure you a better fill price on your stock -- but only when they get filled.

For a stock that’s quickly crashing, a market order may be your only option.

Another type of stop order is the trailing stop, which is used primarily to lock in gains. As your position increases in value, your trailing stop ratchets higher and higher, but it only triggers if your percent-decline or dollar-value-decline conditions are met.

In this trailing stop example below, the blue trailing stop line can climb with the stock's price (in white), but it doesn't move lower when prices retract. That one-direction movement helps to lock in gains.

BLACK CHART

Source: Bloomberg.

The Value of Stops for Technical Traders

It doesn’t surprise me that stop losses are so controversial. For a fundamentals-only investor, stops can be downright terrifying. The oft-described stop loss nightmare comes from the fear that an investor will get stopped out only to see shares rocket in the ensuing weeks and months.

Part of the problem is that fundamental investors can only base their stop loss levels on how much pain they're willing to take. If you're not willing to take more than a 10% hit on a stock, that's where you place your stop -- regardless of the market conditions.

Stops are perfectly suited to technical trading, though. That's because technicians base stop levels on key areas of support and resistance (in the case of a short-side trade, of course), areas that act as intermediate price floors and ceilings for shares of a given stock.

That’s even more significant because generally a broken support level or trend line means that the technical setup is broken and it's time to get out of shares.

If you're riding the uptrend in WM below, then the 70-day moving average on the chart is a smart place to put a stop. Because it's acted like a good proxy for the bottom of the trend, it's essentially a trailing stop.

WM CHART

In the below breakout trade, $9 was a smart place to initially place your stop right after the buy triggered. After all, if shares violate support at $9, then the pattern is broken, and you don't want to own it anymore.

UAM CHART

Fundamental investors see deteriorating business metrics, such as debt increases or revenue drops, as a reason to unload shares. Because technical investors use market conditions to determine whether a trade is still worth owning, stops make a lot of sense to use.

Picking Out Your Stop Loss Levels

Implementing stop losses in your trades isn't as difficult as it first appears. I've long held that any trader worth his or her salt has an exit strategy in mind before ever placing that first trade. You should be well aware of the conditions that break your technical setup ahead of time. Not surprisingly, you'll want to place your stop loss at those levels.

To learn more about determining support and resistance levels for your stops, check out the primers on Support and Resistance, Moving Averages, and Trend Line Support.

Of course, picking stop loss levels becomes tougher in practice. Intraday whipsaws can trigger stops even if shares trade low for just a few minutes on a given day. To combat that, placing stops several percentage points below a support level is an effective method. While it will mean that you get a lower fill price if a stop does get hit, the chances of seeing that stop violated are significantly lower.

Another effective way to use stops is by not using stop loss orders at all. Instead of using “hard stops” (real orders that can trigger on a certain price break), attentive traders may want to consider mental stops that are tied to alerts generated by your trading platform. While more subjective than hard stops, some experience in the markets can often help you determine whether that intraday stop violation is likely to hold, or whether it's just a whipsaw. Deciding to honor stops only when a stock closes below your condition prices is another way to accomplish this same objective.

Mental stops can spare you some unnecessary losses, but they also require experience and attentiveness to the markets. If you have a day job, opt for the peace of mind that hard stops provide -- just keep them from being too close to your support levels.

While stop losses will likely continue to elicit impassioned opinions from investors for the foreseeable future, knowing the specifics about implementing stops can help limit your risk, lock in your gains, and take some of the emotional impact out of your next trade.

This article is commentary by an independent contributor.

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