Most traders and investors are familiar with stop loss orders but few actually use them in their trading. The reason is that stop losses are often viewed as a tough balancing act between keeping a tight stop to minimize losses and "smothering" the stock by having the stop so close as to be stopped out by any minor decline. In this article I would like to present a recent actual trade in EZCorp, Inc (EZPW) as a case study that demonstrates how using stop losses can be made simple, safe, and very profitable.
Just as a refresher, let me briefly explain what stop loss orders are and what is their use. A stop loss can be used whether you have just bought a stock or sold it short. In the case of a long position (you just bought a stock, hoping it will go higher) a trader will place a stop loss at some price below the current market price. If the stock price declines to the stop loss price, the stop is "triggered" and the order automatically becomes a "sell-at-the-market" order and the position is sold out. A trader or investor might enter a stop loss 5% below their buy price (for example), thus limiting or stopping their loss at no more than 5%. There is certainly no set rule for the level where the stop should be placed - some traders limit their loss at a certain percent, i.e 5%, 10%; others will place a stop just below a key technical support level (or just above key resistance if they have sold short).
The truth is, determining the level of your stop loss is more of an art than an exact science. However, by applying a couple of simple rules of thumb traders can limit their risk while still getting the most out of the price move.
Conviction. Protecting one's capital begins even before a trade is entered. By carefully selecting the stock and their own entry point, traders will stack the odds heavily in their favor and have a strong conviction that the trade will work out. This confidence will allow traders to place their stop loss several percent below their buy price without undue concern over minor price gyrations.
I bought EZPW at $34.25 on June 27th. The reason for my trade was the breakout above resistance of $33.30 that day on very heavy volume (see chart). Also notice the breakaway gap between June 26th and June 27th which was not filled. Both heavy volume breakouts and breakaway gaps are strong indicators that a new uptrend is beginning. In addition, the overall market was in a rally at the time. For all the above reasons I had a pretty strong conviction that the trade would be successful.
On some occasions a breakout would be entirely reversed the next day with the price going back to the old resistance level or even lower. Keep in mind, I am expecting that the breakout is the beginning of a new uptrend, so if the stock does not act accordingly, I plan to close the position without delay. In most cases the price would pull back just slightly before continuing higher. With that in mind, I placed my initial stop at $33.45 allowing the price to pull back (up to 2.33 % against me), but above the old resistance level of $33.30 which if reached would effectively cancel the breakout.
Expected Risk/Reward. Everyone's trading style is different. I know from past experience that, if successful, my trades usually make 10 to 15% profit, while if unsuccessful I lose about 2-4%. I checked my technical-based stop level of $33.45 against these risk/reward expectations. Closing a losing position at $33.45 (a 2.33% loss) would fall well within my average loss, so I knew I was not taking a larger than usual exposure with this trade.
If the stock moves higher after the breakout day, the stop loss order should be raised too. An old Wall Street rule, that a trader should never break, says that a stop should only be moved up or left unchanged, but never be lowered back down. Sometimes, traders grow attached to a stock that has made them a nice paper profit and are reluctant to sell it when it shows signs of weakness. In such situations many are tempted to lower the stop loss, so they don't have to sell the stock. A paper gain is just that however, and a sign of weakness is the exact time to sell and convert it into a real profit.
In the case of EZCorp, the price continued higher the next day and I raised the stop. (See chart below.) Great care should be taken that you do not up the stop to try to protect every penny the price advances, as this will cause you to prematurely exit the trade just as it is starting to work out. If you had bought EZPW at $34 and watched it climb to a high of $35.70 the next morning just to close at $35, you may wish you had a tighter stop, but that would be the wrong way to think. Instead of being obsessed with intraday price changes, ask yourself these questions: "Did the stock close higher today?," "Does the uptrend look healthy?," "Is there evidence that the move is over?"
A trader who worries that their 3% profit would turn into a 2% profit, will likely not ride their stock to a 10 or 15% gain. Traders should better wait until the charts show clearly that the move is ending or reversing, and not focus on the price not closing near the high of the day or engage in "ticker watching."
The above chart shows each of the times I adjusted my stop loss in EZPW, with the time entered and the price level of every new stop. I did not follow the price too closely, and for 3 days (June 28th, 29th and 30th) I kept the stop unchanged, as the price did not advance much. As EZPW began climbing again, I continued moving the stop, usually placing it below the most recent lows. On July 6th, EZPW gapped and opened above $38.60 just to crash almost immediately down to almost $36.60. Although the stock stabilized later in the day, I knew that the closed morning gap signified that the move was coming to an end. The next morning (July 7th) the price gapped again and started another sharp fall right after the open. Fearing a replay of the previous day's action or worse, I raised the stop loss to a level where if the price did not halt its freefall just below the open, I would sell before it goes down too far.
My stop loss at $37.95 was hit, and with the bid dropping so fast I was sold at $37.84. Certainly not the best execution, but my take on the move ending was correct. EZPW continued to pull back over the next several days. My correct use of stop loss orders allowed me to capture virtually the full extent of the move and exit just as the price started to reverse.