The decision to enter a trade is emotional. Having invested time, energy and mental capital, we want to see our decisions work. After all, we developed a good idea and are convinced we are correct, so why allow the market to chase us from our position?
This introduces one of the more difficult decisions a trader can face – when to use a stop loss order and when to give the trade room to work. As an example, consider two trades I have done in the past year.
Last December, I did a great deal of fundamental analysis and decided that Zale’s (ZLC) business was doomed. With the shares trading at $16, I went short with a downside price target of $8. As the chart shows, the stock initially moved against me and then collapsed. Had I used a stop loss I would have realized a loss as opposed to a large gain.
The second example would be a technical trade of Baidu.com (BIDU) I highlighted in my weekly newsletter EPIC Insights. I liked the bullish setup and went long when the stock traded near $220. As the chart below shows, a quick collapse occurred. Having identified this as a high risk trade, I used a stop loss of $205. The result – a quick loss, but much better than the collapse a buy and holder investor has suffered.
So how do we decide when to apply a stop order and when to take market risk? For me, there are three things to consider:
1. Faith in your research – If you believe the thesis is correct and the market has missed some key factors stick with the trade.
2. Discipline – Once you have made a sell decision stick with it. Never start with a stop order and move it to avoid taking losses.
3. Flexibility – You may believe you are right, but process all new data objectively. If you made a mistake in the initial assessment, move on.
By following these simple rules you will maximize your gains and avoid large losses.
Sean Hannon, CFA, CFP is a professional fund manager and weekly contributor for StockTradingToGo.com. He runs EPIC Insights Weekly, the free Sunday market newsletter, and is the founder of EPIC Advisors, LLC.