In previous articles I've covered some of the basics of
technical analysis as well as given an extended metaphor for the
difference between technical and fundamental analysis. Often
times I throw out the term "risk management" without giving a
real clear cut definition of exactly what I mean. Here we'll
explore an essential part of risk management, the stop loss. At
the end of the day, that's what it's all about anyway.
Some investors trade without using a stop loss on their
positions. This is okay for someone who truly is buy and hold on
a long term scale. If you are using technical analysis in your
trading, then I feel that a stop loss is necessary for each and
every trade. Basically a stop loss is the rip cord on your
parachute. It's the eject button in your investing jet. A stop
loss is an order to close out your trade at a predetermined price
level. When you are actively trading, it's an essential tool that
helps you exit a losing trade without letting your emotions get
in your way.
There are several ways to determine where to put your stop
loss on a trade. A common stop loss is setting a price 8% below
your entry try. Why 8%? Simple math really. If I buy a stock at
$100 and sell at $92, or 8% below my entry, then my next trade
only needs to be a 10% winner to make up for it. $92 plus 10% =
$101.20. Even if my trades have a 50/50 chance of working out for
me, I'll make a little money over the long run with these
I like to be a little more scientific than the blanket 8%
approach in my trading. What I try to do is buy stocks just above
a support level then put my stop loss on the other side of the
support level. It's like putting a safety net below a trapeze
artist. The initial support is the high wire the acrobat is
walking across and the stop loss stops the messy scene of
crashing to the ground. Given the trading style I use, stop
losses are often placed below the moving average I use.
) gives us an example where the moving average can be used to
determine a stop loss. Currently this Zacks Rank #1 (Strong Buy)
stock is trading at $4.70 and has moving average support down at
$3.61. Most of the time I don't like having a stop loss 23% away
from my entry. I see the distance between price and support
as risk and in this case probably wouldn't enter the trade
because of it.
Another popular way to incorporate stop losses in trading is
using the indicator known as "Parabolic S.A.R." Don't let the
complicated name turn you off to this simple method. The S.A.R.
stands for "Stop and Reverse." The indicator shows up as little
dots above and below the stock price. Parabolic S.A.R. dots above
the stock price indicate a downtrend, while dots below the stock
price show an uptrend. The price levels at which the dots are
placed can be used for stop losses. The indicator switches sides
based on price hitting these dots, hinting at a change in the
trend for the underlying.
Zacks Rank #1 (Strong Buy)
) has been a big mover the last few days. Applying parabolic
S.A.R. to find a stop loss we can see the yellow dots below the
current price, indicating an uptrend. The dot's value at $57.04
would serve as the stop loss value in this example.
It's important to determine exactly what kind of trading and
investing you are doing prior to setting your stop loss. What's
also important to remember is that stop losses can and should be
moved, but only upwards and never downwards. By moving a stop
loss up you are essentially minimizing your risk on a trade and
locking in gains. For example, an investor looking to make money
on momentum stocks is probably looking for a larger gain than a
trader that looks for range bound large cap stocks. You want to
"let the winners run" as they say. After the momentum stock turns
in your favor for a bit, moving your stop loss to break even is a
great way to play with the houses money and lower your risk on a
trade to nothing. I try to move my stop to break even as soon as
I get a chance.
Another way to find a good stop loss point is using the
"average true range" indicator. The average true range, or ATR,
calculates the average daily range of a stock over a specified
period. Stocks that are more volatile are going to have larger
ATRs than less volatile counterparts. Traders will use a multiple
of this ATR in order to find a stop loss. The thinking is, if a
stock trades lower by say twice its average range then it is
likely not in an uptrend.
Taking a look at the very volatile
) you can see how ATR spikes during periods of volatility. The
recent movement in the stock has helped push the ATR all the way
up to 13.99, meaning on average NFLX moves almost $14 a day.
Using a 2x ATR stop loss on today's price that would mean an
entry at $374 and a stop loss down at $346. Just to clarify, I'm
not telling you to go out and buy NFLX today. The technical
picture is not what I look for. Although it is a Zacks Rank #1
Every trader that uses stop losses in their trading does so in
a different way. Your own personality is going to be the best
guide as to which stop loss calculation you should use in your
portfolio. If you are a subscriber to technical analysis then
stop losses should be a cornerstone of your trading plan.
NETFLIX INC (NFLX): Free Stock Analysis
SMART TECHNOL-A (SMT): Free Stock Analysis
VERMILION EGY (VET): Free Stock Analysis
To read this article on Zacks.com click here.