We have established why a stop loss order is a requirement
for the successful investor. Now let's look at some of the simpler methods.
There are 3 basic methods (and many more we will not discuss
here) for stops that almost anyone can master. They are percentages of the
price action, moving averages and support areas. These cannot be covered in
detail here, but you can do further research on your own.
Any stock, fund or Exchange Traded Fund (ETF) you buy you
think is going to go up, but there is the chance that it may go in the other
direction. The stock you buy is $50 per share. You certainly don't want to hold
it while it goes to $25 or $10 as many did in 2000. Your first thought should
be how much am I willing to risk if I am wrong and that is called your loss
limit. Let's pick an arbitrary amount of $5.00 per share. That's 10%. If it
goes down that is the maximum amount you will lose and you still have 90% of
your money remaining to find a better investment. When it goes up you will want
to protect your profit by moving the stop up.
When an equity advances to $55.00 your stop of 10% should be
moved to $49.50 that is 10% 0f $55. When it goes to $60 your stop is now $54.
Nothing complicated here. There have been many stocks that gone from $20 to
$250 and then down to $2.00. Think what a stop loss would have done for you in
that case.
As I have said before never buy anything unless it is going
up. That same $50 stock was moving steadily higher in a rather narrow trading
range. If you decide to use a 20 day moving average you will have to do the
calculations either daily or weekly. You add up the closing prices for the past
20 days and divide by 20. This should be done once each week and the number
calculated is your stop loss. Again nothing complicated. The steeper the
advance the shorter should be the number of days for the moving average. If you
are lucky enough to have one of those skyrockets you might even be down to a
5DMA. Some traders use a 50 day MA and others even a 200day MA. Mutual funds
lend themselves to the latter,
Finding support and resistance points requires a more
sophisticated approach. This is something you are going to have to study. There
are many places on the Internet that have short explanations with examples of
how to determine these points.
Briefly you watch a stock, fund, ETF run up and then you see
it stop and set back like a stair step. It will rest for a while with a short
up and down sideways pattern that forms before the next move higher. Your stop
should now be down at the point the recent up move started. When it advances
again this current formation becomes the stop loss point. This is not
mechanical and requires a more experienced trader to determine these points.
Once you learn this technique you will also begin to see the orderliness of the
market.
The mastery of an exit strategy with stop loss orders will
immediate put you in the top 10% of all investors. Learning how to sell is the
key to successful investing.
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