Stop-Loss Orders And Where To Place Them

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It's difficult to stress the importance of placing and maintaining stop-loss orders protecting your stock investments. With the Graham Investor method of investing, one might think there is such a margin of safety involved that stop-losses aren't needed. Nothing could be further from the truth.

If you are buying a house, the three most important pieces of advice anyone can give you are: "location, location, location!" With Investing they should be: "preservation, preservation, preservation!" Of capital, that is. This is best illustrated with percentages.

As an example, you may buy any number of stocks in a $10,000 portfolio. Without stops, if you lose 20% of the value of your $10,000 (i.e. $2,000) you will need to make 25% on the remainder to get back to where you started. Likewise, if you lose 50% and are left with $5,000 you now need to make 100% profit to get back to where you started. How many people make 25% in a year? Not many! How many people double their money in a year? Even fewer!

You might think you won't lose 50% of your investment, but it does happen, and a lot more regularly than any of us care to admit. So, always use stops.

Once you have established a buy point, you can work out where to place the initial stop. There are several ways of doing this:

1. Place the stop one tick below the most recent resistance level or swing low.
2. Use a fixed percentage, e.g. 8%, 10%, 12%.
3. Use volatility as a guide. Take a 14 day moving average of the High-Low range for the stock (including gaps). Use a stop of 2.5 to 3 times this range.
   

Since we are generally longer-term investors, we use 1 or 2, or a combination of both such as 1 for the initial stop, and then 2 for the trailing stop once the position has moved significantly into profit. Just use what you feel most comfortable with.

According to William O'Neill of CANSLIM and Investor's Business Daily fame, a stop of 8% is more than adequate. However, be aware of the different volatility of particular stocks and use your judgement. Also make sure at least that your initial stop is further away from the price. Experiment,and discover your own tolerance for risk. Or make up your own stop-loss strategy.

An unusual system for placing stops I had some success with was to use the long-term average S&P annual gain of 11% and multiply it by the stock's beta, if the beta is greater than 1. Round this number up or down. Simplistic but effective. If a stock has a beta less than 1, just use 11%. CRDN has, as of 07/07, a beta of 1.307. The stop, if we were buying today would be 11*1.307 or 14%.

14% my seem like a lot to lose, if the stock falls after you buy it and hits the stop; in a diverse portfolio, this will not happen too often and you will be protected from having to make a 100% gain to break even. Most discount brokerages allow percentage trailing stops nowadays, and may not even charge
for them, giving you peace of mind for free.

Copyright: (c) 2005 The Graham Investor