Using Stop Loss Orders to prevent an Investing Disaster
Many investors fail to use a Stop Loss Order to protect themselves in case they end up buying a stock at the wrong time. In his book "How to Make Money in Stocks" William O'Neil states even the most successful investors maybe wrong about 50% of the time when choosing stocks to invest in. The key is to cut your losses early when a stock fails to follow through to the upside and minimize your losses. However many investors fail to do so and allow a small loss to turn into a much bigger one by not using a proper Stop Loss Order.
A good rule of thumb is to never let a stock drop more than 8% below the Pivot Point when it reverses to the downside after initially trying to breakout. Thus this is where a Stop Loss Order would come into play.
Let's look at a specific example. CLZR first formed a Double Bottom pattern in 2002 and then traded sideways for 12 weeks while developing a Handle. While forming the Handle CLZR traded roughly between $6 and $7 with its Pivot Point near $7. CLZR then broke out strongly in February and above its Pivot Point (point A) and rose to $10 very quickly. In this case a proper Stop Loss Order should have been placed 8% or so below the Pivot Point of $7 near $6.50.
After rising very quickly and stalling out near the $10 level CLZR had then completed the right side of a 2 year Cup. Over the next 10 weeks CLZR traded sideways again between $7.50 and $9.25 while developing a Handle. Then in April CLZR broke out again and rose to $12.50 rather quickly. In this case if you had missed the original breakout in February you got a second chance in April and should have placed a Stop Loss Order 8% or so below CLZR Pivot Point of $9.25 near $8.50.
Remember its always important to use a Stop Loss Order just in case a stock doesn't perform the way you think it will. Allowing a small 8% loss to turn into something much bigger can be avoided by using a proper Stop Loss Order as the example below shows.
Imagine if you would have bought AMZN right before it peaked in the late
part of 1999 (point A) near $120 and failed to use a proper Stop Loss Order
once it began to sell off. If you had invested $5000 in it during the latter
half of 1999 and used an 8% Stop Loss Order you would have lost only $400 as
it sold off. If you had held on to it and rode it down to the $10 level
which occurred in the Fall of 2002 you would have lost over $4000 instead.