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Stop Loss Philosophy

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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 parameters.

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.

Smart Tech 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) Vermillion Energy (VET - Free Report) 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 Netflix (NFLX - Free Report) 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 (Strong Buy).

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.

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