The first, necessary question you need to ask is whether or not you want (or need) to place a stop at all. There’s a ton of debate on this point, and people tend to have strong opinions about it, one way or the other.
If the market you’re trading in doesn’t allow stops, the question is an easy (and automatic) one to answer, but a great many markets allow stops, and as you branch out, you’re going to want to give the matter some thought.
If you opt to use stops, the first question you need to answer is, for any given trade you enter into, at what level will you sell in order to control your losses?
Two important things here. First, write this down! It doesn’t matter whether you express the stop level as a percentage or a dollar value – the key thing is to write. It. Down. The reason that matters is that if you’ve written something, you’re much more likely to hold yourself accountable to it.
Second, you need to determine if, when, where and how you’ll be using a stop BEFORE you enter into a trade. If you shrug and figure you’ll do it after the fact, it’s overwhelmingly likely that you won’t, because once you make the trade, you’re invested in it, both financially and emotionally, and your psychology will work against you.
A careful read of the above will not another compelling reason for making a decision about stops. If you make a firm decision about when you’ll be pulling out of a trade should it go south, then you know with certainty what your risk is. You know exactly how many dollars are at risk, and YOU are controlling that value, not the market. That’s huge, and one of the key secrets to long-term investing success.
If you can’t decide one way or another about using stops, have a look at some alternative scenarios:
1) If market conditions don’t take out the stop, nothing happens.
2) If the price hits the stop, and then keeps falling, dropping far below your stop level, congratulations. You preserved your capital, controlled your losses and lived to fight another day. The stop did its job.
3) If the price hits the stop, but only falls marginally after that, you have another opportunity to consider the trade, and may decide to re-enter the position. This “second chance” automatically gives you a greater degree of objectivity, which is a very good thing.
4) The price drops below the stop, taking it out, and then heads back the other direction. If you use stops, this is going to happen. Learn from it. Maybe your stop parameters were too tight. Maybe you choose a poor entry position. Observe the market behavior and try to make a determination about how you could have used your stop more effectively in those instances.
In looking at these alternative scenarios, we think the case is clear. Stops are an invaluable tool in your investing arsenal, and we strongly recommend their use. They give you some measure of control even during those times when you’re not able to sit at your computer screen watching the price levels like a hawk.
Note that so far, we’ve only been looking at stops as a means of controlling your losses, but there is another valid use case for them, and that is to close out a position once you’ve achieved your target level of profitability from the trade in question.
This closes out your trade and “locks in” your profits. At that point, you can re-assess whether it makes sense to re-enter the trade, or to use those funds to pursue some new opportunity that has arisen. Used in this manner, stops are a good hedge against the psychological factor of greed, which can keep you from taking profits after your targets have been met, and ultimately burn you when the price starts turning south again.