Some time ago, I wrote about how to use stop-loss orders to save your investment at the stock markets. The „stop-loss“ order is only the tool – you have to use it wisely and get comfortable with it in order to get the maximum benefit from it. Today, I want to write about how to put this tool to use for you and your stock investments.
Let’s see how this works in detail…
1. Methods for determining the ideal value for your stop-loss order
I believe you want to make the best investment decision and therefore setup a safety net for your investment in case the stock prise will take an unintended direction. I think you are smart enough to know that technology today can help you achieve your investment goals more easily. And you are right!
After you have acquired stocks or ETFs, there are several methods of determining the a „good“ stop-loss level. This stop-loss value represents the ideal balance of chance and risk management based on your willing to take risks and your experience.
The most frequent used methods for determining the ideal corridor for stocks are based on:
- stock chart support levels
- stock chart moving averages
- the simple percent method
The first two require you to take a more detailed look at the history of the stock chart whereas the percentage method simply deducts a certain percentage of the current value as your stop limit. If you have made a decision to buy stocks chances are you have taken a look at the charts to back up your belief in rising value anyway ;)
2. The three methods explained
Support level method
First, let’s elaborate on the stock chart support level method. Let’s take a look at the picture:
We see the stock chart going up and down (black line). A turning point from a rising value to a falling value is called resistance. The turning point when the stock value stops falling and rises again is called support. When you look at the history of a stock chart, you will see many resistance and support levels in the past. When using the support level method, you decide to set your stop-loss (fixed or trailing) to the value of the latest support level. This is show in the image by the horizontal dotted line at the latest support level.
Moving average method
Second, there is the moving average method. How does it work?:
Very often you find a „softened“ stock chart line within the regular chart. This line can be switched on by most online brokers or websites providing financial information. Available for several time frames (day, week, month) these lines show the averaged stock price. So these averaged lines don’t have the same volatility as the stock’s normal chart. When a long term (month) moving average line crosses a short term (week) moving average line this indicates the ideal value for you to set up your (trailing) stop-loss level if you want to follow the moving average method. The intersection of the longer term moving average and the short term moving average would mark the ideal stop-loss in the image above.
Last but not least, there is the fairly simple percentage method:
When a stock or ETF has a certain value e.g. $60 you can just set your (trailing) stop loss order at a certain percentage below the current value (based on observed volatility over the past). If you decide to risk 10% of your money when you bought the stock for $60 – then $54 would be your (trailing) stop-loss limit based on the percentage method. This method is fairly easy. The most important part is to take into account the volatitlity of the stock to not set the stop-loss value to „tight“ to the stock’s current value. Then, a minor small drop could already lead to a sale of your stocks due to the stop-loss order.
3. A word on volatility
As I said, you have to take into account the volatility of your stocks in the past when trying to find an ideal stop-loss value. This heavily depends on the industry and market conditions your stock is from. I specialize myself on the high tech / internet industry which tends to be (much) more volatile than classic industries like steel, car makers or like ETFs or index certificates (Dow Jones, DAX etc.). It’s important to take volatility into account when determining the ideal stop loss position because if you place your order to „close“ to the current value, you run a very high risk of getting your stocks sold because of small bumps in the stock’s chart.
Beware: On stocks only traded in small volume professional investors tend to use this against other investors by selling a relatively large amount of their stocks, sending the course south and then triggering stop loss orders of other investors – just to buy themselves back in at a now lower price and push other investors out of that stock. So don’t set your stop loss limit to tight – leave some room according to the expected volatility of that stock.
4. Setup your stop loss level
After you have chosen your method for determining the ideal stop-loss value based on the stock’s industry, expectations and experience – you can finally setup your (trailing) stop-loss order by telephone with the help of your broker or within the web portal of your online broker (which I highly recommend!).
After that, your stocks have somewhat entered autopilot mode as long as values are rising or at least not dropping below your (trailing) stop-loss value. Personally, I keep 2-3 interesting stocks in „standby“-mode. If any of my stock positions hit the stop-loss barrier and is therefore sold (or shortened) I have to decide if I reinvest the cash gained from the stocks sold into the stock market again. If I decide to reinvest – my standby stocks of interest might come into play.
I recommend you to watch and adjust your stop-loss level from time to time. First, I would have a look at them every 2-3 days. With more experience you can have a look at them once a week and adjust the stop-loss values if you want. You can do this very quickly if you use an online broker. Just make it part of your weekly routine.
Anyway, you can now sleep well knowing that your risks have been taken care of and the stock exchange computer system does the monitoring for you. With the (trailing) stop-loss order you have the perfect trade-off between profit and risk!
5. Thank you
I wanted to finish by just saying „thank you“ for reading my blog and wishing you the best of fortune at the stock exchange. If you have a question, please let me know. I’d love if you would leave a comment or say hi to me on my Facebook page. Thank you very much :)