There are any number of reasons why you might buy into a stock.
Perhaps you’re a technical wiz, scouring the charts to find an entry signal. Like a breakout above a former price resistance level, or a moving average crossing over another.
You might go purely on fundamental analysis. You assess the financials of the company, the sector and the economy. You check out its management and find out how its competitors are faring. You want any information you can get your hands on.
For some, they buy shares based on a tip in a newspaper. Or maybe it’s nothing more than a hunch, or a tip from a friend.
Whatever the reason, once in the trade, the harder part is knowing what to do next. Not just setting a profit target, but what to do if you get it wrong. That is, if you buy in and the share price tanks.
That’s where stop losses come into play. We all know about them; it’s impossible to read any trading material where they are not covered. The aim is simple: to help limit losses on a trade.
More than one method
Perhaps the most common stop loss strategy is price. That is, once the share hits a pre-determined price level, you know it is time to exit the trade.
How and where you set that price level depends on your strategy. It could be at price on the chart which shows that your original premise no longer stacks up. For example, you buy into a breakout but the share price reverses.
If the trade does go your way, you can use a trailing stop to lock in profits. By doing so, it helps avoid a situation where a winning trade turns into a loser.
The stop loss level needs to give the trade enough room to move. But not so loose that you give away too much money if the trade goes wrong.
For most — whatever method they use — the price is the overriding factor. It’s not really surprising, given the way we calculate success or failure in the markets.
If the share price rallies to your target, you know how much your profit will be. And conversely, if it falls to the stop price, what your loss will be.
It fits in with how we measure success in the market. That is, on our profit or loss.
What often gets overlooked is the other thing on the price chart…time. It’s easy to focus too much on price, and not enough on time.
For an active trader, lost time can be as damaging as losing money on a trade.
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How long is enough?
Sometimes when you buy into a stock, the share price can simply go against you. It continues to fall away until it triggers your stop loss.
However, you don’t have to hold onto a losing position until it reaches the stop. You can cut the position before that happens, if the reason you bought the stock no longer applies.
For example, if you are expecting an earnings upgrade but it doesn’t materialise. Or you think a commodity price will rise off the back of an inventory report — instead the report shows a glut.
The reason for cutting the trade is that the premise for buying it no longer holds.
But what if the share price goes sideways? It’s not unusual to buy into a stock and it does completely nothing. It trades sideways seemingly forever, without finding direction.
The thing about time and the premise (for the trade) is that they are related. The very reason for buying a stock is that you believe there is something that will cause the price to rise.
As I say, it could be an earnings upgrade. It might be that you think sales are improving, or that the underlying commodity the company produces will rally.
Whatever is behind your decision, you are buying the stock for a reason. A part of that reasoning is when you think the price catalyst will occur. That is, the very thing that will bring other buyers into the market. Otherwise, there is no point to the trade.
And it is this that helps you decide when to exit the trade. You don’t have to wait for the price to fall down to a stop loss level. Instead, you can give the trade a fixed time — enough for the anticipated move to occur — before you decide to exit.
For a day trader, it might be minutes or hours. For others it might be days or weeks. A time stop helps you decide when to exit — irrespective of price — if the move you are anticipating doesn’t pan out.
By using a time stop, it also enables you to make best use of your capital. To allocate it where you think it has the best chance of success. That means not holding onto stocks aimlessly without a genuine reason for owning them.
All the best,
Editor, Options Trader
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