When you buy a stock, apart from your purchase price, you should have two figures in mind:
· the price at which you'll take profits (your exit price); and
· the price at which you'll accept that the trade has not worked, and cut your losses (your stop loss order price).
We'll deal with exits in a future article, so for now let’s look at the stop loss order level. How do we arrive at this figure? The most common method is to identify nearby areas of support on the chart, and to set the stop one or two ticks beneath that support – if the support is broken, the price may be headed further down. The support line for Amazon.com can be clearly seen on this chart from stockcharts.com:
Other methods include using a fixed percentage (e.g. sell if the price falls 4%), volatility stops (using a multiple of the Average True Range, the average amount the stock moves each day), or even time-based stops (exit after five days). It would be wise when setting your stop to avoid round numbers, as they're likely to be tested – so in the example above try to avoid setting the stop at $60, try $59 instead.
Don't move your stop loss order!
Actually, setting the stop is easy – the hard part is TAKING ACTION WHEN YOUR STOP IS HIT! One way to encourage self-discipline is, rather than having a ‘psychological’ stop which may never be acted upon, to actually enter your stops into the market as sell orders – but you'd be surprised how many sell stops get cancelled as the price falls. Brokers jokingly refer to these orders as CIC orders – Cancel If Close! The logic (if there is any) is that you think the stock is ‘as low as it can go’, and just needs a bit more ‘breathing room’. It's also easy to remember the times when your stops were hit, only for the price to rebound and soar – imagine having a stop of $60 on your Amazon stock in January 2000 (see the chart above) – you would've been stopped out, and then seen the price rise to $85 within a week!
So yes, it does happen that you'll sometimes ‘be right’ to cancel, or more accurately ‘get away with it’, but the times it happens are not enough to make up for the losses. Your maxim should be ‘Cut your losses and let your profits run’, and hard stops placed in the market are the only way to make sure you cut your losses. You are likely to be wrong 50% of the time, so just deal with it! When you find that you can take action on a loss as easily as you can act on a profit, you'll have made a major advance in your level of trading.