Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Mastering The Basics Of Stop Placement

|Includes: IBM, KO, SPDR S&P 500 Trust ETF (SPY), T

Prior to the financial crash of 2008 there was an ongoing debate between fundamental and technical analysts as to whether investors or traders should use stops. The severity of the decline convinced many that stops should be used, according to MoneyShow's Tom Aspray.

I have always advocated placing a stop order at the same time as your buy or sell order. It allows one to roughly quantify the risk of any investment or trade. By analyzing the risk it often becomes clear that the risk is too high. One of the most common mistakes is to raise the stop instead of lowering the entry level. If you are going to adjust the parameters in order to lower the risk focus on changing the entry not the stop.

In addition to the process of determining the initial stop, it is important to also manage the trade once a position is established. This is an art more than a science as every price pattern has subtle differences. Though I follow a systematic approach, the rules are not cut and dried. Clearly when to sell is an important decision in terms of managing one's portfolio and can be the key factor in determining whether you are profitable or not.

Those who follow my daily column have been able to follow both the placement of the initial stop as well as how the stops are managed once a position is established. Because of time and space constraints the specific details of the stop choices are generally not provided. The goal of this lesson is to provide those details, and in the process provide more insight so that you can improve your bottom line.

Click to Enlarge

In this first chart I would like to look at a historical example so I can share some of the basic guidelines that I try to follow. This will be followed by actual examples of trades and stops I have recommended in the past year.

This chart of the Spyder Trust (SPY) covers the period from March 2003 through early August of 2003. On March 12, the SPY made a low of $79.38 but then closed near the day's highs. The volume was strong that day and increased over the next few days as the on-balance-volume broke through resistance. Seven days later on March 21, there was clear evidence that SPY had bottomed as it had moved well above the highs of the past six weeks on strong volume.

My favored strategy is to buy on a setback after an uptrend has been established. So on March 21, a typical recommendation would have been to go 50% long at $86.06. This was just above the 38.2% Fibonacci retracement support at $85.84 and above the round number of $86.00. The second 50% buy level was at $85.28, which was midway between the 38.2% support and the 50% support at $84.60.

The initial stop would have been at $82.88, which was below the 61.8% support at $83.37 as well as the $83 level. The approximate risk would have been 3.2%. It was also below the low of March 17 ($83.22). which the candle shows was a strong up day. Both orders would have been filled between March 27 and March 31 when the low was $84.40.

Click to Enlarge

The Spyder Trust (SPY) made a new rally high on April 7 and when this high was exceeded on April 22 (point 3) the stop would have been raised to $85.82. This was below the previous swing low. On May 5 when SPY closed at $93.03 the stop could have been raised to $87.86, which was just under the mid-April low.

As I have discussed in the past I favor closing out part of any position when I can get a decent profit in a relatively short period of time. This, of course, reduces the risk to your portfolio and also has psychological benefits. To determine the profit taking levels I use a combination of Fibonacci and chart analysis.

In this instance the 127.2% Fibonacci retracement target was at $91.42 but the chart suggested that SPY could move back to the December 2002 high of $96.05. The 100% or equality target could be calculated using the net change of the initial rally from the March lows ($10.50) and adding it to the late March low of $84.40

This gives you a 100% target of $94.90, which is noted by a red line on the chart. It was hit first on May 12 and would have been a reasonable level to sell half of the position. SPY did move sideways for several days at this level before correcting.

For more on Fibonacci targets see "Profiting From Fibonacci Entries and Exits"

By May 28, SPY had moved to new rally highs (point 5) and the stop would have been raised to $91.29 (red line), which was below the prior swing low as well as the May 2 low.

The 161.8% target at $101.39 was hit on June 6 as the high was $101.40. After a one-day pullback SPY again closed at new rally highs on June 12 (point 6) and the stop could have been raised further to $97.33 (red line). As it turned out SPY peaked three days later and the stop was hit on July 1 (point 7).

On November 1 in The Dow's Most Overbought Stocks there were several stocks, which showed very positive monthly technical patterns. One was International Business Machines (IBM), which had overcome ten-year resistance in 2010. At the end of October (line 1), it closed at a new three-month high, suggesting that a new uptrend had begun.

Click to Enlarge

Therefore I recommended "going 50% long at $178.72 and 50% long at $176.20 with a stop at $164.32 (risk of approx. 7.4%)." The 38.2% Fibonacci support of the rally from the August low to the October high was at $177.79 with the 50% support at $173.86. The mid-October low was $176.25, therefore I felt then that a good area of support was between $175-$178.

Click to Enlarge

On November 25, IBM dropped to a low $177.06 (point 2) hitting the first buy level but not the second. Though the rally in December exceeded October highs the bullish monthly analysis suggested keeping the stop wide (line 3) at $164.32. In early January 2012, IBM dropped as low as $178.38, which was a surprise. After bouncing back to the December highs in early February, point 4, the stop was raised to $178.80, which was just above breakeven point.

By March 1, the uptrend had clearly resumed and the stop was raised further to $186.92 (point 5) as IBM was close to the $200 level. This stop was below the early February low and still quite wide since only a 50% position had been established. On March 16, IBM had a high of $207.53 and four days later the stop was raised further to $193.64 (point 6).

On April 3, IBM spiked to a high of $210.69 but gapped lower the next day, which was a troubling sign. The correction found initial support in the $202 area and with the positive close on April 12 (point 7), the stop was tightened a bit further to $196.46, which was just under the early March lows.

In hindsight, at least part of the position should have been closed out on the rally into early May when IBM had a high of $208.92. The five days of tight ranges were a clear sign that the rally had lost upside momentum. The stop at $196.46 was hit on May 18 (point 8).

Click to Enlarge

The monthly starc band scan of oversold Dow stocks at the end of November had the Coca-Cola Co. (KO) at the top of the list. KO had traded in a tight monthly range for four months and was retesting the ten-year breakout level from 2011. Therefore I recommended (line 1) to buy at $66.24 or better with a stop at $62.76 (risk of approx. 5.3%).

Since KO subsequently split 2-1 on July 10, the prices and stops have been adjusted to buying at $33.12 with a stop at $31.38. The buy level was at the flat 20-day EMA and the stop was under both the August and early October lows (red line) at $31.38.

KO rallied sharply into the end of the year closing just above $35. The following correction lasted until February 15 (point 3) when it looked as though the correction was over. The stop was therefore moved to $33.19, which was below the year's lows at $33.28.

Click to Enlarge

The volume surged in March as the OBV broke through major resistance (line a) and on March 22 (point 4) the stop was raised further to $33.88. The rally picked up steam by the end of the month as it hit a high of $37.19. In December I commented that there was resistance going back to 1998 at $75.44 or on an adjusted basis at $37.72.

The correction held the 20-day EMA as the low was $35.92 so on April 18, I raised the stop to $35.61 as it appeared that KO was ready again to move higher. On May 1, (point 6), which turned out to be the high in the Dow, I recommended selling 1/3 at $38.60, keeping the stop at $35.61. This was under the mid-April lows.

The bounce at the end of May made me nervous as on June 1, just three days before the market formed a short-term bottom I raised the stop to $36.33 (point ), which was just hit on the correction low of $36.28. There was a good opportunity to get back in at the end of June, point 9, but I did not spot it. KO eventually peaked on July 31 at $40.66.

Another stock from the December scan was AT&T (T), which had recently corrected and had support from the prior four months at $27.29. The recommendation (line 1) was to buy at $28.54 or better with a stop at $26.90 (risk of approx. 5.7%). The very attractive yield of 6.8% was also a plus.

Click to Enlarge

The strong action just before the end of the month suggested the rally could go further and I was looking for a subsequent pullback to buy. The stop was below $27.47, which was the lowest low going back to August. It was also below $27, and whenever it is possible, I prefer to place a stop underneath a number like $27 as opposed to just above it.

The low on December 17 (point 2) was $28.51 and by early January the stock traded as high as $30.46. The correction into the end of January held the 50% Fibonacci retracement support of the rally from the November lows to the January highs. The reversal from the lows was positive and on February 1 the stop was moved to $28.88, which was just below the prior swing low.

More on AT&T, Rules on Stops and What's Next

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.