Stop, Halt, Arretez-vous: Control Your Investing Risks

	Elliott Gue PF Newsletter.com
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Some successful traders use fundamental analysis and a careful review of financial accounts to select their positions. Others, who are equally successful, rely solely on charts and technical analysis. But the one characteristic that all great traders share is careful, disciplined risk management.

The key isn't to be right on every stock you buy or sell short. Rather, it's deceptively simple: Control risk on your losers and try to maximize your winners.

The best way to accomplish both tasks is to use stop orders to your advantage. Let's review.

Defining a Stop

Stop orders are simple instructions you leave your broker to automatically sell you out of a position at a certain price. For example, you buy IBM at $100 and set a stop order at $90. Once IBM touches $90, your broker will sell you out of the position at the best available price.

You don't need to be monitoring your position when the stop is activated or even be near your telephone or computer.

In the Advantage Portfolio, we recommend an initial stop on every trade. This defines the maximum loss we're willing to accept. Take this initial stop into consideration when you decide how much stock to buy or short.

For instance, if we recommend a stop 10 percent below the current price and you don't want to risk more than $500 on the trade, consider a position size of about $5,000.

By contrast, for volatile stocks, we may recommend a far looser stop--as much as 15 to 30 percent. Then you should use smaller position sizes on these trades to keep your dollar risk within a comfortable range.

We always recommend you set some stop when you initiate a trade. The beauty of stops is that they take the emotion out of your trading.

If you reach your maximum risk point, you're automatically out--there's no waiting for the stock to "come back." Remember: Hope and emotion are the mortal enemies of successful traders--stops eliminate these emotions.

Trailing Stops

Initial stops do nothing to help you lock in a profit. That's why we use trailing stop orders in the Advantage Portfolio.

Trailing stops are moved higher as a stock rallies to lock in incremental gains on the trade. For a great illustration, check out our chart of Advantage-holding Bema Gold.

We initiated the Bema position on August 11, 2003 when the stock was trading around $2.08. Bema is volatile, so we suggested a wide initial stop at $1.35--our target was a move above $3.

Note what happened to Bema in September. The stock began rallying, crossing above $2.50 by the end of September. Based on our initial $2.08 entry point, the profit was already solidly above 25 percent by the end of the month.

It would be silly to allow a 25 to 30 percent gain to evaporate into a loss. So, we raised the stop to $1.95, reducing the risk to slightly worse than breakeven. Moving the stop reduced risk but left plenty of room to make money if Bema continued rallying.

And the stock did just that throughout October and November 2003. In almost every issue of PF, we recommended raising the stop.

By the end of November, Bema was trading around $4.00--a full point above our initial target--and our stop was sitting at $3.63. That stop locked in a gain of about 75 percent on the trade, but gave us even more room to profit if Bema continued to run.

The trade was stopped out in late December at $3.63 and we accepted the gain.

Remember, our initial target was just $3. If we'd sold out at that in early October, we'd have accepted a 45 percent gain on Bema--not a bad performance.

Yet by using trailing stops, the final profit was almost double that target. With trailing stops, you can let your profits ride while keeping your risk in check, rather than just selling out of a stock once it reaches your target.

Rule of thumb: As soon as a position reaches 10 to 15 percent profitability, start increasing your stop orders more aggressively to lock in gains. At a minimum, you should raise your stop to near breakeven at that level.

And when your profit surpasses your initial target on a trade, consider switching to a very tight stop that locks in the lion's share of your gains.

Choosing a Trailing Stop

How and where do you place your trailing stops? There are several ways:

The most common is to use basic technical analysis to identify key support and resistance levels for a stock. You should place stops under key support for longs and above key resistance for shorts.

Chandelier stops are another excellent method. They use a measure of volatility known as Average True Range (ATR) to calculate appropriate stop/loss levels.

For an advanced primer on stops, check out our free report available to PF subscribers at www.pfnewsletter.com/stops.

Elliott Gue will be available to take your questions until Monday, December 7. Please use the form below to submit your questions.