How to Lock in Your Profits by Using Effective Stops

[micro]

This little trading tip can and will make a difference in your trading results in 2009.

Stops are enormously important part of a traders arsenal of trading tools. Some traders confirm that stops are the most important part of their trading armour.

So here are three ways to use stops to protect your capital and lock in profits from a trade. These three money management techniques can be used in stock, futures and forex trading.

The important rule is that you do use a real stop in the marketplace. A friend of mine joked with me that that he had never seen a “mental stop” filled electronically or in the pits.

If the market is good your stop will not be hit. If the market is bad or changing direction then you’ll want to be out of it anyway. That is why stops are so crucial to trading success.

Here are the three most commonly used types of stops. Which one do you use?

1) Dollar Stop
A dollar stop, is when you set a predetermined dollar amount to a trade. Let’s say you want to risk $500 on a grain trade or $750 on a stock trade. Once you get your fill back from your broker or electronically online you simply figure from your fill price where to put your stop.

Pros: Easy to implement and use.
Cons: Can place stops too close in a volatile market

2) Perncetage Stop
Percentage stop, is a very simple way for you to place a stop on a position. Here’s how it works. Let’s say your trading account is 100,000 dollars and let’s say you only want to risk 1% of your total portfolio on any one trade. You simply take a $1,000 risk which represents 1% of your over all portfolio. This can help enormously in avoiding taking BIG LOSSES. A 1% loss is easy to absorb. A 30% or 40% loss in a trade is an account killer, and should be avoided at all costs.

Pros: Easy to implement and use.
Cons: Can place stops too close.

3) Chart Stop
Chart stop, a chart stop is where you place a stop that is either above or below a crucial chart level. The good thing about a chart stop is that this level is often used by other traders. That can both be a good thing and a bad thing, here’s why. Using either one of our first two examples only you know where the stop is. With a chart stop, a great many traders/brokers know that is where the stops are. In an illiquid market this type of stop should not be used, as many times brokers gun for the stops. In a highly liquid and active market this is a good stop to use.

Pros: Very easy to implement and use.
Cons: Can’t be used in thinly traded markets.

[thegreatgate]

This exit strategy is simply a dollar stop but it is a technique that has saved myself from a financial catastrophe many a times:

Say you buy a stock at $10/share and it jumps to $11 and you are quickly up 10% but you are not ready to take profits. Reasons being you like the company, you think their future is bright, and you think you may have found a winner. Then all of a sudden you start to notice the stock is sliding just a little bit; maybe it closes at $10.75. Then the next day at $10.55.

In these types of situations where I am up 4-6% but "not satisfied" with taking the profit I set up a dollar stop exactly at the point where I break even after paying the buy and sell commission fees. So if I bought the stock at $10/share but after calculating in the $15 buy/sell commission fee my break even point is $10.07; it will be the exact number I use for a sell stop. So it gives your stock some room to come down but if it comes down to your break even point then you will be 100% sure to get out without losing a single dime.

Then, and especially in today's type of market environment, you can usually purchase the same stock for $4-$6 a week later and you get those "damn I'm glad I sold" feelings everyday you see "your" stock sink lower and lower each day. Once in a while, however, the reverse happens, where maybe the stock drops to $9 but a week later it spikes much higher and you wish you would have held on through the downturns.

[Hampton]

I'll second thegreatgate...