A few weeks back, I kicked off the Intelligent Investor Series as part of my weekly commentaries. Th...
Where Should You Set Your Stop Loss?
06/11/2009 12:01 am EST
Many investors struggle with the task of determining where to set their stop loss levels. Investors don't want to set their stop loss levels too far away and lose too much money if the stock moves in the wrong direction. On the other hand, investors don't want to set their stop loss levels too close and lose money by being taken out of their trades too early.
So, where should you set your stop losses?
Let's take a look at the following three methods you can use to determine where to set your stop losses:
1) The percentage method
2) The support method
3) The moving average method
The Percentage Method for Setting Stop Losses
The percentage method for setting stop losses is one of the most popular methods investors use in their portfolios.
One reason for this method's popularity is its simplicity. All you have to do when using this method is determine the percentage of the stock price you are willing to give up before you exit your trade.
For instance, if you decide you are comfortable with a stock losing 10% of its value before you get out, and you own a stock that is trading at $50 per share, you would set your stop loss at $45, which is $5 below the current market price of the stock ($50 x 10% = $5).
The Support Method for Setting Stop Losses
The support method for setting stop losses is slightly more difficult to implement than the percentage method, but it also allows you to tailor your stop loss level to the stock you are trading.
To use this method, you need to be able to identify the stock's most recent level of support. Once you have done that, all you have to do is place your stop loss just below that level.
For instance, if you own a stock that is currently trading at $50 per share and you identify $44 as the most recent support level, you should set your stop loss just below $44.
You may be wondering why you wouldn't just set your stop loss level at $44. The reason is you want to give the stock a little bit of wiggle room before deciding to exit your trade. Support and resistance levels are rarely accurate to the penny, so it is important to give the stock some space to come down and bounce back up off of its support level before pulling the trigger.
The Moving Average Method for Setting Stop Losses
The moving average method for setting stop losses is more simple than the support method, but it also allows you to tailor your stop loss to each stock.
To use this method, you need to apply a moving average to your stock chart. Typically, you will want to use a longer-term moving average as opposed to a shorter-term moving average to avoid setting your stop loss too close to the price of the stock and getting whipped out of your trade too early.
Once you have inserted the moving average, all you have to do is set your stop loss just below the level of the moving average.
For instance, if you own a stock that is currently trading at $50, and the moving average is at $46, you should set your stop loss just below $46.
Just as in the example above using the support method, you should set your stop loss just below the moving average to give the stock a little room to breathe.
Watch the video below to learn more about each of these methods and for examples of how to use them in your trading:
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