In my blog last week, I was stressing the importance of placing limit orders when buying your stocks, but this week I also want to stress the importance of using stop losses. Unlike day traders, most of us are not sitting in front of a computer all day watching the markets unfold. We are going about our busy lives with work, families, and other commitments. We do not know if our stock is tanking during the course of the day and we won’t know until the markets have closed and we are checking our balances in the evening. If there was only a way to trigger an automatic sell order if the stock is falling beyond what we are willing to accept. There is. It’s called the stop loss order.
A stop loss is a very important tool that helps you manage your losses when (not if) they happen. If your stock opens the day at $100 and closes the day at $90, that’s a 10% loss and could very well be beyond your risk tolerances. If you are willing to accept a 5% loss, but no more, you would put in a stop loss at $95 so if the stock is dropping during the day, a market order is automatically initiated at $95. (It’s important to remember that if you have a market order at $95, it does not mean it will get filled at $95. There has to be a buyer at $95 too. This risk applies mainly to thinly traded stocks. Stocks with large trading volumes normally do not have this problem.)
So where do you place your stop loss? The answer depends on your goals, timelines and risk tolerances. Personally, I am trying to generate a 2% gain in a week. You must allow for intra-day fluctuations and for the odd day where the stock is going in the wrong direction. Having said that, the stop loss that works most effectively for me is at 3%. If I buy a stock at $100, once the order is filled, I immediately place a stop loss at $97 and go about my day.
The reason I use a 3% stop loss is quite simple. When I look at the stocks I buy, it is very rare that if the intra-day low goes beyond the 3% level, that it will come back and make a 2% profit within a week. It can happen, but it is rare. IF the stock is down 4 or 5%, it can rebound and show a 2% gain, but it might take 3-4 weeks or longer which is beyond my timeline. Worse still, it could fall even more. You must draw your line in the sand. You must remember that there are times when you will be wrong and you must put your ego on the shelf and admit defeat. You also must keep in mind that, overall, this is a percentage play, and your 2% gains far outweigh the 3% losses.
Stop losses are an important tool when buying a stock and helps you manage risk. The order is pre-set meaning you do not have to be in front of your computer terminal all day. It is done automatically. It is an integral part of risk management and part of our tactical plan with twopercentgoal.com. Next week, I will discuss how to use the stop loss to help maximize your gains.
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Good luck with your investments.
Al