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A Short Guide to Using Stop LossesBy Brian Hunt, editor in chief, Stansberry & AssociatesMonday, August 17, 2009 What's so great about a 25% stop loss?
As the publisher of trading and investment advice to thousands of people, this is one of the most frequently asked questions Stansberry Research receives each year.
You see, starting around 1996, our own Dr. Steve Sjuggerud began performing a great service to the readers of financial advisories. He started urging investors to use a pre-determined point at which they would sell a position if it didn't work out in their favor... rather than exiting positions by "feel." These points are called stop losses.
Steve chose to promote the stop-loss percentage of 25%. It's a nice round number that protects investment capital – while still giving positions some "wiggle room" to ride out natural market fluctuations.
But let's lay a common misconception to rest right now: There's nothing magical at all about using a 25% stop loss. It's simply a good "middle-of-the-road" stop loss. If you buy a stock at $10 per share, your stop loss is 25% less than that, or $7.50. If that stock climbs to $20 per share, you "trail" your stop loss behind it and move it to $15 per share.
The real "magic" in Steve's philosophy is the act of enforcing discipline on himself and his readers. The magic is forming a plan before you make the investment or trade... so you're not trying to decide what to do when you see awful headlines... listening to panicky co-workers... or seeing hard dollar losses on your computer screen.
You simply note your exit strategy and carry out the plan. It's like driving with a map rather than randomly taking turns and hoping you get to where you need to go.
So... if 25% isn't magic, can you use 10% stop losses? Or 21.7% stop losses? Or 30% stop losses?
Absolutely.
William O'Neil – a master stock trader interviewed in Market Wizards – encourages readers of his newspaper Investor's Business Daily to use an 8% stop loss. This will result in more frequent losses than most are used to, but it definitely keeps folks away from catastrophic losses.
Or take mining stock traders. These stocks are among the world's most volatile assets. A wide, 50% stop loss works well with these. Option traders often use big stop losses, since options can be so volatile.
No matter what percentage you decide to go with, make sure to remember that position sizing (read about that here) works hand in glove with stop losses. You'll want to place less money in trades that feature wide stop losses (like 25%-50%)... and you can place more money in trades that feature tighter stop losses (like 8%-25%).
It's the discipline involved that is "so great" about 25% stop losses... not any exact number. Having a stop loss will keep you from saying a classic loser's mantra, "I just never know when to sell."
Master this aspect of your strategy, and you'll always keep losses small, you'll always know when to sell, and you'll always be a profitable trader.
Good trading,
Brian Hunt
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Crude oil down more than 4% on Friday.
Chinese stocks starting to show cracks... big China ETF (FXI) down 7% this month.
Junior mining stocks surging... Western Copper, L and L, Minatura Gold, Continental Minerals, and Bayou Bend all make fresh highs.
Cotton falls maximum allowed on Friday after hitting 11-month high earlier in the week.
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