How to Determine Stops and Profit Targets

02/01/2012 11:30 am EST

Focus: STRATEGIES

Buff Dormeier

Senior Vice President - Investment Officer, Wells Fargo Advisors

Volume expert Buff Dormeier discusses how he determines when to sell, and why stops need to be tailored to the stock you are trading.

Buff, how do you know when to sell?

Well, Karen, I think that investors need to have an objective sell point—a discipline about when they sell, particularly in a secular bear market like we’ve been seeing over the last several years. Having an objective sell point takes away the emotion of investing, and one of the things that we don’t want to do is make emotional decisions. We would rather make logical decisions.

So my selling methodology incorporates three important things. One is support. Where have buyers came in the past and bought previously? Knowing the support level is important because that’s where buyers are likely to reside and support the price. If those buyers are no longer there, then that stock could have further downside to go.

The next thing is to understand the stock that you’re in. Each stock has its own volatility. A stock like Coca-Cola (KO) may move 5% a year. A stock like Google (GOOG) or Baidu (BIDU), it may move 5% a day. So if you use a certain percentage, that percentage may not apply to the stock that you own.

For instance, if you put a tight stop on Google or Baidu, you’d be stopped out maybe intraday, and if you put a loose stop on a stock like Coca-Cola, you may never get stopped out and miss out on other opportunities. So it’s important to understand each stock and its own volatility and adjust your risk discipline to the stock you own.

The third important point in selling is to understand what’s happening with the volume. If the volume is supporting the price trend, you can loosen up that stop because there’s more and more people participating in that price movement.

However, if your stock is appreciating and fewer people are participating in that move, you might want to tighten up that stop. That way, you protect yourself should the trend turn against you.

And you mentioned support. Does that same tenet hold for resistance as the market goes up and sellers come in?

Yes. Support is an area where buyers reside, and resistance then would be an area where sellers reside. So if you’re thinking about target prices and where you might want to get out and take a profit, you should understand where those levels are in the past and where investors have perceived a high level of value in the past and have exited.

And keeping those targets in mind and the stops and support will help you manage your risk?

Absolutely. Understanding where to get in and where to get out is particularly important in a sideways or bear market.

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