Setting a Sell-Stop

Some people say you should keep your exit price in your head and enter a sell order when price drops below it. There are two things wrong with this approach. First, it means that you have to be constantly monitoring the market. This is not an option for most people with a day job. Now, even if you have the time (and the inclination) to sit around and watch the markets for days on end, there is still a problem. When price swings down and hits your mental stop, most people hesitate. While they are wondering if price will come back, it drops further, causing more consternation, and often more hesitation.

The people who advocate mental stops or "soft stops" say they don't like placing a stop order with their broker because once the broker places the order with the exchange then the stop order becomes visible and manipulators will drive stock prices down just far enough to hit the stops and pick up the stock at a bargain price. Part of this assertion is true. There are people who manipulate stock prices and they do go gunning for retail traders' stops.

But the reason manipulators can succeed at this practice is that most retail traders place their stops badly, making it easy for their stops to get hit. They tend to put their stops at multiples of 5 or 10 dollars. Never do this. If the stock is trading in the $10 range, put your stop 20 or 30 cents below the nearest dollar level. If it's trading in the $100 range, put your stop 2 or 3 dollars below the nearest multiple of 10.

Setting a stop is a balancing act. If you set it too close to the price action, it is likely to get caught by normal volatility, almost assuring a loss. If you set it too far away, you can stay in the stock longer (so if an upward move develops you're still in it), but if price moves against you, then you lose too much before the stop takes you out of the position.

Consider the following scenario: You buy a 200 shares of a stock at $44.45 and you want to put on a protective stop at 10% of your purchase price. $44.45 minus 10% is very close to $40. In this price range $40 is a major psychological impedance level. This means if the stock goes into a minor decline, there's a good chance that it will move down close to $40, possibly wandering back and forth across that level, and then move back up. If you have a stop order in at $40, you can pretty well count on it being hit. But if you put your stop just 2 percent further down, at $39.20, you get almost as much overall protection and it is much less likely that your stop will be hit unless price breaks through the $40 level and is headed even further south.

There is more to placing stop orders. When I get some time, I will discuss stops in more detail, but for now there are three important things to remember about placing protective stops:

1. A stop order is like a seat belt. It won't stop accidents from happening, but it will keep them from killing you.
2. You have to put it on before getting underway.
3. If the place you want to put your stop turns out to be a psychological impedance level (a nice round number), put your stop 2 or 3 percent lower.