Avoid Serious Losses By Knowing When to Sell

Investors are buying with both hands right now… that’s why it’s crucial to know when to sell.

In the last five trading days, the S&P 500 has rallied nearly 9%, prompting investors to call out the “all clear” signal as stocks ratchet another 1.4% higher this morning. But investors who pile into stocks this week must have short memories — after all, just two weeks ago, stock had their worst Thanksgiving week since 1932.

That doesn’t mean that you should be running from the market this week — instead, it means that you need to enter your next position with an exit plan in mind…

Whether you’re a buy-and-hold investor or a daytrader, an exit strategy should be something you think about before you ever hit the “buy” button on your trading platform. Not only will a sound exit strategy help you skirt serious losses, it’ll also help you to lock in gains on positions that are already in the green.

It all comes down to one major tool: the stop loss.

Basically, a stop loss (or stop, or stop order, etc) is an order with your broker to sell your shares in a particular stock automatically when its price hits a specific level. While there are several different types of stop losses, these three major types are worth knowing about:

1. Stop Order: Triggers once your stock reaches a specific target price, the stop price.

2. Trailing Stop: Triggers at a specific change in price, measured by either percentage points or dollar value.

3. Stop Limit Order: Similar to the stop order, except for the fact that a limit order is triggered once your stock reaches a specific target price. (i.e. sell high, and re-buy low)

Which order to choose depends on what you’re trying to do. Clearly, the biggest benefit of placing stop losses is the fact that you won’t have to lose sleep over your open positions — if the stocks you own take a big dive, your positions will sell off before any major damage is done. That’s a pretty compelling case for using stops.

But there’s more to an effective stop loss than just that.

Using a Technical Stop Loss

For fundamental investors, a stop loss is an arbitrary level that’s set at some “maximum pain threshold”. In other words, if the biggest loss you’re willing to take on a stock is 10%, you’d set your stop order 10% below your cost price and be done with it.

Unfortunately, there’s a big problem with that mentality…

The problem with placing arbitrary stops is that there’s no logical basis for them. After all, shares could fall 11%, then reverse higher — that’s why it’s important to set your stop levels based on the market rather then on your personal thresholds.

To do that, you need to add some basic technical analysis to your investment strategy. Stops can be very useful when they’re placed under a stock’s support level (the price level that a stock has trouble falling below). That’s because to a trader, a price level below support generally means that the stock could be breaking out much lower. Essentially, you’ll want to place stops just under where you’re likely to find a glut of demand for shares.

To avoid exceeding your comfort zone on a loss, think of your “maximum pain threshold” as a dollar amount rather than a percentage. Then, size your position so that you’re stopped out before your losses exceed that level. Trailing stops, which are typically used to lock in gains, can be used a little bit more arbitrarily.

It’s tempting to follow the crowd right now and buy stocks blindly as they climb higher. But doing that would be a big mistake.

Volatility remains a major concern, and it’s very likely that the S&P 500 will see another major drawdown in 2011. Set your stops logically, and you won’t be caught unaware if that happens.