What is a stop loss and how should it be applied ?

This is one of the most mis-understood areas of stockmarket trading. We always get asked a number of questions in our classes.

It can be the only thing, if used properly, that can mean the difference between success or failure. In all of the study and research we have done over the years, all of the most successful stock market traders continue to say that stop loss placements is the most important aspect to trading.

A stop loss is a way of using the chart to determine where it is, that the stock you have bought into, has failed and you should therefore exit the trade in order to keep your capital intact. This is a critical money management procedure as well as one that ensures you don't end up losing money simply by continuing to hold onto a losing position.

Attached is the daily chart of Solution 6. I will demonstrate how we would use stop loss management in this situation.

When placing your trade the first thing we would determine is the initial stop loss level. Lets say for example, when Solution 6 broke out of sideways accumulation back in January, you decided to buy the stock above this level at $1.36. The first place to set your stop loss is under the last low on the daily chart. This was on the 15th January at $1.01, so you can set the stop loss at about 99cents in this case.

Why do we suggest this level ? Because if the stock breaks underneath this level it is highly likely that a change in trend will be in place and the stock will continue to trend downwards.

The next day the stock does move down a little but not as far as $1.01. From there the stock moves higher again on the next day therefore forming a higher bottom on the daily chart at $1.28.

When a higher bottom is formed like this, we suggest that you raise your stop loss level one or two cents below this new low, in this example to about $1.26. Continuing on, the stock tops the day after at $1.48 and then proceeds to move back down to $1.28 over the next 2 trading days.

At this point, although the stop loss has not been triggered it has come close. You therefore should be ready to trigger your stop loss if the stock moves down to $1.26. The next two days the stock moves sideways, however the day after this it proceeds to break under $1.28 and down to $1.24.

For those who are actively watching the market during the day, they should have taken their stop loss at $1.26. Those who can only watch the market after work hours, it is still possible to take your stop loss the next day. More often than not you will still get time to exit safely the night after the stop loss has been broken.

As you can see this system is a way of managing your open positions in the market. If the stock does not proceed to make a lower bottom, you will not be stopped out. If it does then you are out with a minimal loss to your trading capital.

Two other rules should be applied to this however.

First, if you have a target exit price on the stock and it reaches this target, you should take your profits at this point.

Secondly never let a profit turn into a loss. Using stop loss placements effectively will ensure this should not happen anyway.