The most challenging task in trading isn't stock selection, market timing, or finding good entry points. The most challenging job is setting stop-loss points. When do you give up on a trade and take your loss?
No matter how analytical you might be or how carefully you plan, there will be numerous times when you are stopped out of a trade or an investment at the worst possible point. It will often feel like your stops are being used by the market to determine the daily. In many cases, the moment you are stopped out, the stock will reverse and go straight back up.
The first thing every trader needs to recognize is that stops will always be imperfect. We can try to optimize our approach, but we are very aware that in many cases, the stops will be less than perfect, and we will be unhappy with the results. Stops will save us great pain quite often, but most folks will focus on the many times when stops have failed them instead.
Once we are mentally prepared to acknowledge that a stop system will always be less than perfect, we can work on finding an approach that best allows us to cut our losses and let our winners run.
There are two basic ways to set stops. Either we use a percentage method or a technical support approach. Some folks use a 'time' stop where they will close out a trade that isn't doing anything after a set period of time, but we will discuss that in the future.
With the percentage method, we determine how much of a loss we are willing to take in advance and set our stop accordingly. A 10% stop loss is quite common. Investor's Business Daily suggests a stop loss be set at 7%-8% below the purchase price. IBD states that "this rule was set specifically at 7%-8% because our research shows that successful stocks rarely fall in price more than 7% or 8% below a proper buy point. If you buy stocks at the pivot point, you may want to cut your losses even sooner. Eight percent is considered a maximum stop loss."
Even if that research is still valid, there will be market environments with elevated volatility where the natural whipsaws will take out an 8% stop very fast. Also, the right stop will be much lower if you are trading volatile small-caps that may move 10% in a day.
If you use the percentage method, you also have to decide whether you want to use a trailing stop. Do you keep moving your stop up and make sure the loss is never more than 8%, or do you leave the original stop in place and give the stock greater room to prove itself? Many traders will loosen stops on big winners and give them more room as they feel they are playing with "house money." On the other hand, there are some traders who will look to take gains into strength rather than on weakness as a stock becomes technically extended.
The technical method for using stops is based on finding key levels on a chart. Some traders will use a moving average such as the nine-day simple moving average, or for longer-term trades, they may use the 50-day. Another technical approach is to use areas of support or resistance as a stop-out point. If you are using technical levels, then you have to be aware that very evident support levels are often targeted in order to trigger stops and wash out weak holders.
Another issue to consider with stops is whether you set 'hard' stops that are automatically executed by your broker or do you set a soft stop that requires you to act when a stock hits a certain point. Some trades only consider stops on a closing basis to avoid meaningless intraday volatility. There still is no magic formula, and if you are using mental stops, then there is a greater danger of not being disciplined and acting as needed.
Regardless of your method, the most important thing is that you are systematic and disciplined. You cannot allow poorly set stops to prevent you from using them in other cases. When they don't work, that doesn't relieve you of the responsibility of using them the next time. If you are systematic with stops, they may hurt you at times, but overall you are likely to be far ahead when you experience several market cycles.
There are two adjustments I make to the stop process to give myself more flexibility. The first is to use different timeframes with different stop levels for the same stock. I may take a big initial position but then use a tight stop on a portion if it doesn't work quickly. That allows me greater leverage to add in the future if my stock picking proves effective.
The second modification I make to stops is the rebuy or the remount. Just because you are stopped doesn't mean you can't rebuy the stock. You don't want to overtrade, but if a stock recovers from a sharp dip and still looks good, technically, there is no reason not to buy it again.
There will never be an infallible system for setting stops, but they provide a form of discipline we must employ to be effective traders. With some tinkering in how you use stops, you can enhance your returns.