This is a reprint from 2003, originally published at MarketWatch:

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NEW YORK (CBS.MW) — The Duke of Wellington once observed: “What makes a great general? To know when to retreat; and to dare to do it.”

The same thinking applies to investors. They must understand when to “retreat,” and have the self-discipline to do so. This is especially true in the present environment. The pre-war “spike” last month shows why. Eight straight up days, with gains of more than 13 percent, makes it too easy to become complacent and forget about risk management.

Once the market lurched into rally mode, I’ll bet many investors let their emotions get the better of them. Ask yourself these questions: Did the best week in over 20 years suck you in without a coherent exit strategy? That stupendous run was followed by the single worst day in over a year. Was it only then you discovered that you had no contingency plan?

Perhaps, then, its time you developed a risk management strategy – including a sell discipline.

A Strategy for Every Market

Bulls and bears alike need to preserve capital and manage risk. These tactics are crucial regardless of whether the market is crashing or rallying, whether there’s a war on or the economy is in recession.

Take the present environment. From studying market history, I believe that major crashes (think 1929 and 1972-74) are followed by years of range bound trading. Until I see otherwise, I expect growth to be anemic, deficits to keep increasing, and business spending and hiring to remain weak. There’s still too much capacity, too much debt, and the increasing possibility of deflation. Despite this, stocks are not at historically cheap valuations. On the bright side, interest rates are at 40-year lows, and that makes present equity valuations a bit more sufferable.

These crosscurrents make it all the more imperative to have a reliable plan – before you run into trouble.

Risk management methodologies are designed to help you avoid devastating losses. The stop loss is the most basic tactic in your arsenal. Stops work because they define losses in advance. They provide an investor with an objective set of criteria for selling any position. This allows an investor to exit a holding before becoming emotionally involved.

Whenever I review a portfolio down 50 percent or worse, I know I’m seeing the handiwork of an investor who lacks a sell discipline.

Why are stop losses effective? Simply stated, there’s only so much any stock can do. It can go up a little or down a little. It can go up a lot — and here’s what is so devastating to portfolios — it can also go down a whole lot.

Investors who avoid the last scenario spare themselves the kinds of losses that are difficult to recover from.

Let’s look at some specific stocks to see how individual investors can apply different types of stop loss principals.


Percentage stop loss

The percentage stop is the simplest of all stop loss strategies. It limits your downside risk by a predetermined percentage of the purchase price. Typical stops range between 8 percent and 15 percent. Longer-term investments can use stops of 20 percent. That will keep you in a stock if a minor pullback occurs, but take you out in the event of a total collapse.

Let’s say you share my expectation of anemic GDP growth over the next few quarters. In those circumstances, one would expect the discount retailers to do well. A favorite in the group is Target (NYSE:TGT) , down well over 33 percent from its 12 month high of $46. We recently looked at Target near $29. If you purchased the stock at that price, your 15 percent stop loss would be $24.65. Any day the stock closed at or below that price is your signal to sell.

Of course, no one has a crystal ball. This idea could be wrong in many different ways. Perhaps the thesis that the U.S. undergoes an anemic recovery is off. Maybe the conclusion – that discount retailers do well in that environment – is wrong. Even if the economic thesis and sector conclusion turn out to be correct, perhaps we just picked the wrong stock from the group.

Regardless of the reasons, once Target trades through my stop point, we part ways. I sell the stock, book a small loss, and wait for the next opportunity.

Stops set below an up trend

Another method of stop losses I like to use is placing a stop just below an up trend. This is a technically based loss limit. It’s designed to liquidate a position in the early stages of institutional distribution (a technical term for mutual fund selling).

For stocks in long-term up trends (remember those?), place your stop loss just below the trend line. They’re easy enough to find. Use a daily or weekly chart, and draw a line connecting the three most recent lows. Place a mark a short way below that line, on the far right side of the chart. That’s your stop loss.

This stop should be monitored as the stock price rises. Review it at least once a month; Active traders review their stops more often, typically weekly (or even daily).

Lets look at some active stocks as examples.

In early 2003, the Nasdaq 100 (INDEX:NDX) stocks were holding up much better than comparable S&P 500 stocks during sell offs. That “relative strength” suggested these NDX stocks would outperform when the markets turned around. Lets look at one popular NDX stock: Nextel Communications (NYSE:S) .

Since narrowly avoiding death last summer, Nextel seems to have regained its footing. Although still way off its all time highs of $80, the stock has maintained a steady up trend on its weekly chart since June 2002, closing at $13.39 on Monday. Holders of Nextel would place their stop losses just below that up trend, at about $10.25.

For stocks in downtrends, the reverse is true. You can place a “buy stop” above the trend line. Hedge fund traders use often a break of downtrends as a signal to cover short sales.

Take the defense sector as an example. Defense stocks rose more than 300 percent from their January 2000 lows to their highs in June 2002. But since peaking, the sector has retraced 40 percent of those gains.

I find it intriguing that investors were dumping defense stocks – or even shorting them – right before a war that may last a long time. Lockheed Martin (NYSE:LMT) is a good example. The break of the recent downtrend was a strong signal for shorts to cover their positions. It might have even been a buy signal.

Stop loss below support

You don’t have to be a technician to see where support is on a chart. Look for the horizontal line that a stock often trades down to, then bounces off. That line reflects the price where institutions find the stock compellingly cheap, and have reliably bought it in the past. Their buying is what usually supports the stock from falling further.

Your stop loss goes right below that level.

When a stock breaks support, it means that institutional thinking about the company may have changed. That break often indicates the stock will head further south.

Buying a stock right above support, with a stop just below, offers a good risk/reward set-up. Downside is limited to a few points, while upside may be substantial.

Oracle Software (NASDAQ:ORCL) is currently trading above its support in the mid $10s. As long as it stays above the $10.50 level, I’m happy to own it. Breaking that level suggests a new, lower trading range. Once that happens, I cut it loose.

Take another look at Nextel, only this time use a daily chart instead of a weekly. It reveals a well-defined trading range between $11 and $14. A buy at the bottom of the channel ($11) would set your stop loss just below support – at about $10.50.

Stop below moving average

One of the most reliable sell signals is the 200-day moving average, or MA. The MA is the average daily closing price of a stock for a specific number of days.

When a stock is rising, its moving average will rise, albeit at a lag. Once the stock begins to falter, its price will fall much faster than the moving average. When the share price crosses the average to the downside, that’s a very powerful sell signal.

Since the market peaked in April 2000, every major disaster — from Enron to Global Crossing to WorldCom — has given clear 200 day moving average sell signals. Every single one.

Lets look at Halliburton (NYSE:HAL) , a heavily shorted oil driller due to asbestos liability concerns. Since it crossed its 200-day moving average to the upside (around the November elections), short sellers have been covering their positions. Just as a downside cross is a sell signal, an upside move through the 200 day often generates a buy signal. Indeed, short sellers often use the 200 day as their “line in the sand.” When a stock crosses the 200, they cover their short positions.

If you were short Halliburton, the cross above the 200 day was your stop loss. If you are presently long Halliburton, you could place your sell stop loss below the 200 day – at about the $16.50 level.
Trailing stops

Any stop loss can be turned into a “trailing stop.” This strategy prevents you from giving back the gains of a winning position.

As a stock rises, you raise your stop loss with it. One strategy is to increase your stop each time the stock enters a new “decade” (forties, fifties, sixties, etc.). Adjust the stop loss based on the weekly – or even monthly – closing prices. This makes it more likely you’ll get the benefit of a rising stock price for as long as possible, while still offering downside protection.

When moving your stops up, it’s a good idea to avoid using round numbers (i.e., 60, 70, 80) because option strike prices can temporarily “pin” a stock to those levels on expiration day each month. There’s a tendency for stocks to trade to just below these levels, and then snap back. For lower priced stocks, try using weekly increments of $5 instead of “decades.”

Conclusion

Prudent investors decide on a sell strategy before getting involved with a stock. They use objective decision-making criteria to keep their emotions out of the process. Like experienced flyers, they know where the emergency exits are before trouble arises.

You can think of stop losses as the “pre-nuptial agreements” of the market. Sign one before you marry any stock (no lawyers required!). You can even use CBS MarketWatch Alerts to send you an email when your stock hits your predetermined sell point. See Alert Watcher.

Stocks almost never collapse overnight. It took shares of Enron , the mother of all disasters, over a year to go from $90 to zero. Without a sell strategy in place, many shareholders were frozen by fear. They rode Enron all the way down. Had they used any of these stop strategies, their losses would have been small to moderate.

That’s the value of risk management. It recognizes that not all investments go your way. Identifying in advance that some stocks will be losers will save your self a lot of grief in the long run — and a lot of money.

(2003 Disclosure — Editor’s note: At the time of publication, Maxim’s clients had long positions in these stock mentioned: Halliburton, Lockheed Martin, Nextel, Oracle, and Target. All expressions of opinion reflect the judgment of the equity research department of Maxim Group LLC at this time and are subject to change. Barry Ritholtz can be reached at britholtz@maximgrp.com ).

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Volatile markets call for stop-loss orders
Commentary: Using stops to limit risk, protect profits
April 1, 2003, 12:02 a.m. EDT
By Barry Ritholtz

http://www.marketwatch.com/story/volatile-markets-call-for-stop-loss-orders

(Editor’s note: Barry Ritholtz is the chief market strategist at Maxim Group, which manages over $4 billion).

Category: Apprenticed Investor, Technical Analysis, Trading

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

31 Responses to “Using Stops in Volatile Markets”

  1. Did you just tip over the dominoes? ;)

  2. bergsten says:

    “My” Public Service Announcement:

    Use stop orders, and keep them to yourself if at all possible.

    Maybe I’m being paranoid, but if anyone knows of your stop orders, they can be used against you. I’ve had times where a stock dipped below my holdings just long enough to trip the stop, then climbed back to where it was — literally in seconds. Kind of like somebody in Arizona swerving off the road just long enough to run over a rattlesnake.

    “Yourself” does not include your broker, your trading account, etc.

    There may well be (and probably are) packages out there that monitor your holdings and react accordingly, but identifying (or creating) them are a subject beyond the scope of this course.

  3. Barry,

    Right idea, wrong methodology. Use in the money call options as as stock replacement.

    Example: You own stock trading at $72 and decide that 65 is the right price for a stop loss order.
    Instead of placing that stop loss, sell the stock now and replace it with a 65 call. You can choose a short-term call or one that expires much later.

    You have now completed all the downside protection needed, but there’s one big bonus. With a stop-loss, you are out when your order is triggered. With call options, you are still in the game.

    If the stock never rallies (after the stop is triggered), you lose little extra (just the time premium in the option). If the market reverses, you still own a long position – with no risk because you already lost all you can lose.

    As a compromise play, you can sell your call options when the stock hits 65, recovering some time premium. In fact, you could easily recover more in time premium (not intrinsic value) that you originally paid.

    http://blog.mdwoptions.com/options_for_rookies/2010/04/delta-neutral-stock-replacement.html

  4. Not just stop losses bergsten but orders in general. I’ve seen times where a stock was trending away from my desired price. I’ve put in a set price and suddenly the stock will stop for a few seconds, reverse course, hit my price and then start back on its original trend.

    Another one is where you will put in an order between the bid and the ask and suddenly the price will jump (or fall) in order to see if you will panic. If you inch closer but don’t take the market order it will happen again. The thing is, if you don’t move, then a few minutes later they will hit your bid and after that things will all go back to the prices they were before you entered your bid.

    It’s blatant! So watch yourself out there folks!

  5. @mark

    If the stock is a dividend stock you lose the dividend that way though. Plus you are also creating two extra transaction costs whereas with a stop loss you have no transaction costs (or capital gains) until the stop is triggered

  6. drey says:

    The trick, of course, is where to set your stop – high enough to minimize potential whackage but low enough to avoid a scenario (we’ve all been there I suspect) where XYZ corp consolidates just enough to trigger your stop before exploding to new highs, prompting one to take a giant bite out of own’s own liver.

    Call me paranoid but there are times when I swear the traders are sitting around going “hmm….we’re gonna take this stock down a ways before taking it back up so we might as well take ‘ol drey’s shares before the big move up. Where did you say his sell stop was set at?”

    Probably need to see my shrink about those meds…

  7. @drey

    It gets a lot easier when your stop level already has a 20% – 50% profit baked into the trade ;)

  8. dsawy says:

    This one nugget bears repeating – often:

    “Prudent investors decide on a sell strategy before getting involved with a stock. They use objective decision-making criteria to keep their emotions out of the process. Like experienced flyers, they know where the emergency exits are before trouble arises.”

    When I read similar things (and read it again on TBP), I started using the technique of trailing stops held on the broker’s server (ie, the order is a market order, automated to fire if the bid drops below a certain point – rather than an order put onto the exchange where it can be seen on the tape at any given time…). As @bergsten says, “keep the order to yourself” – in other words, don’t put a hard limit order out there for everyone to see. If your broker doesn’t support a way to put a limit order into only the broker’s computers without flashing it on the exchange, find another broker.

    On Schwab’s system, these private orders are called “alerts.”

    As Barry says in his piece, think of it like a pre-nup – with the psychology of the pre-nup. In other words, you sign a pre-nup BEFORE you get hitched. When you buy a stock, you should already have a plan for what reasons you will sell it – and a trailing stop or limit order put in when you buy the stock will help you stick to your plan.

    They also allow you to do something other than watch the market every day.

  9. Purewater says:

    If an investor used this advice for their gold and silver (those come to mind, I’m sure there were manyothers) purchases over the last decade, they would not have made a dime. A buy it and forget it gold/silver investment strategy had made 2x to 4x their money. Of course, the opposite would have been true in the 1980s. Just sayin’…

  10. I was referring to stocks, not commodities, but the main point is still valid and applicable. Always use tools to preserve capital, and never allow any position to be come a giant money losing debacle.

    So when Gold collapsed from 1200 to 200 on the 1980s, any of these stops would have avoided most of the down draft. If you bought gold in 2003 (when we recommended it along with Crude Oil) you could have used any of these stops to handle the pullbacks. Once you are stopped out, nothing prevents you from buying back in . . .

  11. Dennis says:

    Really? Someone is STILL advocating Buy & Hold — AFTER these past 3 years?

    That is unconscionable

  12. drey says:

    “It gets a lot easier when your stop level already has a 20% – 50% profit baked into the trade”

    HCM -

    Wish that was the case with more of my trades, though I am sitting on a nice gain in UUP and debating where to set the stop as we speak.

  13. Stops can get ‘blown through’, no?

    Whatever happened to simple Put Buying?

    though, this: “Always use tools to preserve capital, and never allow any position to be come a giant money losing debacle…”, as BR reiterates, above..

    has to be The Takeaway.

    simply, “Ya gotta be around, to be around..”
    ~~
    and, contrary to ‘Conventional Wisdom’, if peep don’t bother to understand this: http://www.riskglossary.com/link/greeks.htm for starters..They shouldn’t play in Traffic.

    Options, far from being ‘too Risky’, are the pre-eminent Risk Management Modality..

  14. Purewater says:

    Barry, Nothing would prevent YOU from getting back in to that trade because you’re an extremely talented money manager. The average investor wouldn’t stand a chance of getting that timing right.

  15. Simon says:

    I think Barry underestimates the skill involved in trading stocks. I can find a trend line and support and place stop losses. Nevertheless because one is intimately involved in essencially a short term process it is very very difficult for an amature to avoid being over taken by the ride and becoming shorter and shorter term in his or her investing methods. Emotions start to dominate and you start to lose money.

    A better method in my opinion is the value investing process. You find a way to value a stock. You buy only at a discount. You sell once it reaches a level where it meets a criteria that would define it as expensive. Say a predetermined price earnings ratio.

    Having said that you could try to confine your buying and selling times to periods where the market is definitely rising on a monthly time frame and vise versa.

  16. DoctoRx says:

    Methinks based on one of his other very recent posts (quoting Alan Newman’s caution) that Barry has downgraded the stock market from Buy to Hold or at least close to that. And we know what that means.

    Too many stocks are too far above their moving averages to suit me.

  17. iratherbe says:

    Okay all well & good. Prudence calls for continual buy, sell & risk mgmt. disciplines. Wonder what context this was first published? If as a check up & reminder … fine. As a caution or warning, well kinda 3 yrs. too late & far after the fact. Could be a heads up, yet the macro-market still had almost 5 years of a mini bull-run to go.

  18. IanMc says:

    Thanks BR,

    For a casual reader / layman like myself this makes a lot of sense. I really appreciate investing 101 advice like this. It’s something simple and straight forward that can help myself and others from making or remaking big mistakes. I will talk to my broker tomorrow.

    I remember a 401k advisor coming to my company and his advice on surviving a bear market as we just went through from Oct 08 to March 09 was to curl up into a ball and “take it” and wait for the bear to leave. I remember feeling angry during his presentation at how stupid it sounded. Now, granted the market came back up 75%, but for a young investor like me I’m still down. If I had an exit strategy I could be enjoying a 40-50% gain instead of a 75% “recovery”.

  19. rktbrkr says:

    $146B to put out a Greece fire. (Anyone want to bet whether those austerity measures never happen?) Danker shoen et merci mes amis, SUCKERS!

    European countries and the International Monetary Fund on Sunday threw Greece a lifeline worth a stunning $146 billion after the financially foundering nation unveiled a stinging program of spending cuts and tax hikes to reduce its enormous government deficit.

  20. rktbrkr says:

    Ian, Nobody sells at the top nor buys at the bottom but liars, your position now vs. what you paid over the years is probably decent – how much time has the Dow spent over 11K since you’ve been investing? Not much.

  21. call me ahab says:

    bergie-

    good point- what you describe happened to me just a week or two ago-

    maybe I will just write it down and sell at the stop price instead of putting in the stop order

  22. IanMc,

    it’s unfortunate that that ****bag gave you the ol’ Clayton Williams routine..

    just remember, their–the 401(k)/MutFund complex– objectives are dissimiliar from your own.

    for them, it’s all about AUM and the annual fees thereon (regardless of performance)..

    as ref., see: “…”Clayton Williams in his own words,” a Richards campaign ad touted “On rape. ‘It’s like the weather. If it’s inevitable, relax and enjoy it.’ ”

    Many believe that remark cost Williams the governor’s race. Even 20 years later, it’s still a political legend…”
    http://cbs11tv.com/watercooler/clayton.williams.offers.2.570545.html?detectflash=false
    ~~
    http://www.wikinvest.com/metric/Assets_Under_Management_(AUM)
    ~~
    http://clusty.com/search?input-form=clusty-simple&v%3Asources=webplus&query=Puts+to+protect+your+Portfolio

  23. TakBak04 says:

    @Simon Says:
    May 2nd, 2010 at 5:09 pm

    I think Barry underestimates the skill involved in trading stocks. I can find a trend line and support and place stop losses. Nevertheless because one is intimately involved in essencially a short term process it is very very difficult for an amature to avoid being over taken by the ride and becoming shorter and shorter term in his or her investing methods. Emotions start to dominate and you start to lose money.

    A better method in my opinion is the value investing process. You find a way to value a stock. You buy only at a discount. You sell once it reaches a level where it meets a criteria that would define it as expensive. Say a predetermined price earnings ratio.

    Having said that you could try to confine your buying and selling times to periods where the market is definitely rising on a monthly time frame and vise versa.

    ——–

    Thanks Simon for your view for those of us who are more individual investors (value..HA!) rather than trading.

    BR had some great points that all of us investors should heed…but, what you are saying is closer to how an investor having individual stocks (who is not a Trader) might find as a way to work these uncertain markets. Set the “Target” for how much “UP” you want your stock purchase to go…(taking into consideration the Dividends and Div. Due Date) and work on selling a certain percentage up.

    And…as Barry said: “if you sell you can always buy back.” So BR’s advice and yours could be combined as a road map for those of us who like to pick our own stocks and not do trading accounts who still want to have a strategy…

  24. TakBak04 says:

    BTW…some of us (shamefully) still own a high percentage of a stock for a company we once worked for. We have been cautioned against keeping such stocks …but some of us worked for companies who are still doing okay…P&G, J&J, etc….and others. So it’s important to have some “STOPS” under those stocks so we don’t lose all like the Enron, IBM, KODAK, Reader’s Digest, and others lost in their company stocks when they were “let go” or even retired.

    Stops for some of the “better names” owned by mutual funds are ones that many of us are reluctant to sell…but given the volatility of our world today…even very “safe seeming stocks” can wipe us out for a long while before they recover. If one needs the money at some point that could be hard. Stops put in laddering could be very helpful to avoid a disaster. And BR…”moving averages” and “Price Points” in charts could be something we should look at.

    BR said:

    “Stops set below an up trend

    Another method of stop losses I like to use is placing a stop just below an up trend. This is a technically based loss limit. It’s designed to liquidate a position in the early stages of institutional distribution (a technical term for mutual fund selling).

    For stocks in long-term up trends (remember those?), place your stop loss just below the trend line. They’re easy enough to find. Use a daily or weekly chart, and draw a line connecting the three most recent lows. Place a mark a short way below that line, on the far right side of the chart. That’s your stop loss.

    This stop should be monitored as the stock price rises. Review it at least once a month; Active traders review their stops more often, typically weekly (or even daily).”

    And Barry cautions to use a “STOP” below where maybe “Traders” would put the price point. Good advice…have watched that in action through the years. You can get wiped out (as other posters have said) if the Traders and MF’s pick a target and then BUY BACK IN while you sold with them. A little below is some protection in case THEY are “playing” with the stock.

    Just My Humble Opinion….

  25. cognos says:

    Generally speaking… in institutional space most of the best guys I have worked with have NOT used stops. I have never even really seen a stop used in about 5 different hedge funds. There are a number of reasons for this… one being that managing larger positions (say $100M+ in liquid names) kinda makes stops irrelevant. (One has to manage liquidity and trading actively.) There are other good reasons.

    That said, I think stops can probably be an advantageous tool for the smaller investor who typically has easy liquidity. I do think stops should not be set too tight. If you want to make 50%… you should be willing to lose 15%. There is NO MAGIC in setting all your stops at -5%. You’ll end up stopping out alot with the name bouncing back and paying plenty of transaction costs in the process… that is just noise.

    Finally… the better way to handle this is just to cultivate a tendency to trim on losses. (Actually I trim on gains too). Generally if I am AT ALL unsure… I am trimming. And then occassionally, we are looking for opportunities to push risk in either key select names / stories (maybe GS here?) or at key points in time (Mar 09? late Nov 08? this past Jan?).

    So consider that as an evolution of stops… sell 1/3? sell 1/2? Re-evaluate the information. Better data-driven decision making (not more trading) is the key to better performance.

    Alot of the technicals stuff posted above is mumbo-jumbo. For every “look how the 200-day MA worked as a sell signal” story, I can find you the opposite. Alot of stocks broke 200-day MA in late Jan. You would’ve been selling at the bottom. Its never that easy… I dont see true pros heavily using moving averages or simple technicals.

  26. rileyx67 says:

    For Doctor Rx, your thoughts were exactly same as mine as was reading this “2003″ piece…Barry, are you getting more and more “worrieder”? No changes yet on Fusion, but a few others I follow and respect are seemingly edging toward bearishness?

  27. Ezwhit says:

    Barry, I noticed you mentioned using the closing price under the percentage stop loss method. Do you recommend using the closing price as the trigger for all methods?

  28. JustinTheSkeptic says:

    Buffett on CNBC, cunningly trying to save face. I guess everybody loves a clown.

  29. To reiterate, I am not referring to stop loss orders — I never trust specialists not to slip prices down to the order, execute them, then bring them back.

    This is about having discipline to sell stocks that are not working out, and avoiding jumbo losses. . .

  30. Mark Down says:

    They’ll be crawing at my cold dead hands trying to get my appl to sell !

  31. [...] Risk management is job one for new traders.  (Options for Rookies also Big Picture) [...]