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.

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