Using Stop-loss can be costly

[EagleTed]

Many financial advisors and talking heads tell you to use "Stop-Loss" orders when buying stocks. You set them up so if a stock falls 10% or whatever rate you set up, the stock is automatically sold. In theory, it's a great idea. Enron investors would have greatly benefited by using them.

In practice, however, be careful. In lightly traded stocks a 10% daily or weekly swing is not unusual, in fact, it's probably the norm. Even large-cap stocks such as XOM can experience large swings, although it's not the norm. But, a too tight Stop-Loss can cost you big time. XOM yesterday (10/23/03) experienced a more than 5% decline at the opening bell, but quickly climbed back to near break-even and actually had a gain for the day at closing. If you had bought it the day before and placed a 5% Stop-Loss on it, you would have lost 5% of your investment for no good reason at all.

If you use them, be careful. If you don't use them, be even more careful, LOL.

[Estragon]

The proper application of the stop-loss order is certainly debatable.

One strategy which has served me well is to calculate the maximum loss I am willing to incur on the transaction, and place the stop accordingly.

I calculate the number of shares to purchase based on this, assuming the stop point to be the previous week's low. Then, to lock in profits, I adjust the stop upward {if the stock rises} to the new previous week low. This strategy is known as the "trailing stop."

By using this strategy, I never absorb a greater loss than I initially found acceptable, but ensure profits when the trade goes as planned.

For example, if I set my maximum loss on a transaction at $250, and I want to buy Pfizer at its closing price on Oct. 27 of 30.97, I would see what the lowest price for the previous week was {30.50}. If it should trade below that, I want to get out at a loss of $250, so I calculate $250 ÷ $0.47 = 532 shares to be purchased. A week later the stock has risen to $31.61, but the new low for the last week is 30.70, so I move the stop to that point. One more week sees the low rise to 31.02, so I adjust the stop, and now I am in profit for the transaction even if the stock drops that low.