What criteria do you use to set stops?
With initial purchases on stock, we look at cutting out if the stock moves against us 7%-8%. Why? We buy when we think a stock is ready to make or is making a move up. If that fails, we don’t want to hang around-something is not right. If it turns back up, we can always get back in when it hits the buy point again. That way we avoid taking a big loss.
After a stock makes an initial move, we relax the 8% rule because we now have a gain and have some room to work with. Strong stocks can move down after a breakout, and we don’t want to be shaken out when the stock comes back to test the breakout. If the stock falls back below the breakout, that is a bad sign, and that is why we often set our first stops after a breakout just below the breakout price. As a stock moves up after our initial purchase and we build a cushion up, then it becomes a different ballgame. At that point, as long as the stock and the market are ‘acting right,’ i.e., pulling back on lower volume consolidations and then moving back up, we will give the stock plenty of room. We will even move without a stop order at all. If things get choppy, however, we start putting them back into play.
Where? That depends on the stock and personal preference. We can watch stocks more, so we can go ‘naked’ without a stop loss. If we are going to be away, however, we either tell our broker or enter a stop at where we feel comfortable. If a stock tends to give back 25% on a pullback after a nice run, we will set a stop right under that 25% level. If it gives back 50%, we may just sell when we think the stock has peaked on the move, and then pick it back up on the next move. When a stock is racing into new high territory, there may not be a support level near term-the pullback on profit taking could be pretty big if the stock has shot up way over its 10 day moving average. At that point, we may just decide to lock in profits with a stop at our own personal comfort level, and then take new positions after the profit taking.
On options, it is a little different because we are using the stock as our guide, but we cannot put a stop in on the stock price, just the option price. Thus, if a stock has support at $100 and we would like to sell our option if it breaks 100, we have to determine what we think the price of the option will be at that time if we want to place a stop order. We can always tell our broker to sell the option if the stock breaks 100, but that requires the broker to be there and on the ready-does not always happen (indeed, doesn’t that always happen at lunch time?).
We can handle that two ways. We can just pull a number we are comfortable with (not very scientific) or we can get really into it (and it is not that hard, really) and calculate where the option should be based on its delta. If a stock is at 110 and you want to sell your option if the stock hits 100, you just have to do some math. Let’s say your option is at $20 (cheap today for an in the money option) and has a delta of 50 (for simplicity’s sake-an in the money option should not have a delta of 50, at least not one we want). A $10 drop in the stock would equate to a $5 drop in the option (110-100 = 10 x .50 = $5). Your option should be worth $20 -$5 = $15 when the stock hits 100. We could set our stop at $14 to give us a margin of error. That way the stock can bounce up off of support at 100 and hopefully keep our option. Does not always work just right-stocks sometimes dip below support before closing above support. That is what makes stops imperfect.
Look what has happened. A $10 drop in a $110 stock is a 10% loss. A $5 drop in a $20 option, however, is a 25% loss. Ouch. Options are different. They give you more upside potential, but they also lose value faster from a proportional aspect when they fall. Thus we don’t use an 8% rule with options. We are inclined to use the stock as our guide. If it is behaving as we want, we will let our option run. If we start to lose value on the stock, we won’t let our option drop to below 50% of the price we paid. We have ridden some right at 50% that ultimately made us money, but we were ready to pull the trigger. That if very tough to do if a stock is basing and looks as if it is going to rise. You have to factor in how much time you have left in such a situation.
For example, on Thursday we added some BRCM options at a decent trade (at the time). The stock then tanked $13 on Friday. Note, however, that the stock tapped its 10 day moving average on its low and moved up. BRCM tried to back to a new high, but missed out. We think that because it did not break its 10 day moving average and the overall market remains positive to us, BRCM will still turn in a good performance for us. Indeed, we are looking at adding to positions if the stock does move up on higher volume from here. We did not have a stop in, but if the stock breaks its 10 day moving average, that will be a signal for us to bail on our new purchase.
