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.
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.
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.
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.