As regular readers know, it’s my belief that the best way to dump stocks is via the use of stop-loss orders, a basic investment technique I’ve been espousing long before Martha Stewart made it famous. To review, a stop-loss order is placed below a stock’s current market price. Should the specified price (or anything below) get traded, the order is immediately executed at the market’s best available bid.

Regardless of whether you take a fundamental or technical approach, stop-loss orders should be an integral part of every trading discipline. They succeed simply by design: By placing one, you’re quietly acknowledging that, yes, even great stock picks can end up as lousy trades.

Stop-loss trades are the bedrock of disciplined trading. Yet the most common problem with stop-loss orders is that they never get executed. Instead of actually placing orders, most folks use “mental stops,” expecting that once a certain price is hit they’ll be available (and able) to make the trade. Few ever are, making mental stops about as useful to a portfolio as mental sit-ups are to abs.

So even with XYZ down 25% from the purchase price, hitting low after low far below where a stop should’ve been placed, many traders will hang on, naively certain that a bottom and rally aren’t far off. Is it denial? Is it delusion? Either way it’s expensive to your bottom line.

All brokerages offer orders on a “good-until-canceled” (GTC) basis, meaning that your stop can be placed weeks, even months in advance. If the market ever trades the stop price, your order is immediately filled. So one need not spend each day huddled over the Ameritrade account. Place your orders and let the market, as I often say, take you out.

Once you’ve committed to trading with stops, the next challenge comes in knowing just where to place them. Some people opt for a technical signal, like placing stop orders at a security’s 100-day moving average. Some use a mathematical approach, selling stocks if they decline 15% from the purchase price or a recent intraday high. Regardless of the approach, the most frequent grievance I hear is from people who complain that their stops always get hit, only to have the market reverse and continue higher.

The real purpose of a stop order isn’t to save a few dollars, but to ensure that you move on from a trade when a market’s trend has legitimately changed. And yes, when you place a stop order a mere 3% below the current market price, it will get hit. So because most stocks, just like a rodeo bull, will try and toss you off before moving higher, it’s much preferable to trade a smaller position with a wider stop rather than a larger position with a tighter stop.

By now it should be gospel: Size kills. And with 15% of your portfolio invested in Taser (TASR) or PetroKazakhstan (PKZ), a tight stop is all that protects against the possibility of catastrophic loss. At the same time, by placing stop orders a mere 3% to 5% below the stock’s current price, you’re just asking — no, begging — for the market to churn you to pieces. Investors end up repeatedly getting stopped out and getting back in, inevitably increasing the position size with each new buy. If you’re looking for an easy way to lose money, this is it.

For the highest probability of success, one should aim to take big chunks, not bite-sized pieces, out of any market move. To that end, if you’re bullish on XYZ, I believe it’s much preferable to trade a smaller position and use a wider stop in order to avoid constantly getting flushed out of your hand. For example, if you were going to use a -10% stop with a 5% position size, I think it’s even better to use a -20% stop with a 2.5% position size.

Nobody knows the future. And by trading a smaller position with a wider stop, you’re actually giving the market a chance to either validate or negate your outlook. Stops placed on uncontrollably large positions end up hanging traders up on the everyday volatility, not protecting them against the possibility of a serious shift in trend.

As we wrote a few years back, trading decisions are rarely black and white — more like shades of gray. And for larger positions, I advocate using multiple stops, a handy approach that works especially well with large, winning trades that might need to be pruned, but not killed altogether.

Say I’m long a big slug of XYZ. With the stock at $50 a share, my first stop-loss order might be near $45, representing a -10% drop in the current market price. At that point, I’d sell a quarter or a third, anywhere up to half of my position. Then I’d wait and watch, setting yet another stop order to protect me should the market decide to continue lower once again.

To me, it’s the most rational approach. As the market weakens, I’ve reduced my risk. But by keeping a portion of the trade in my account, I give the stock a chance to rally back with my holdings still largely intact. If XYZ marches back up to $50, I’ve still got skin in the game and, depending on my outlook, can quickly re-establish a full position. It hurts to sell losers, but it took me many thousands of dollars to realize that success in the market comes not in fighting the trend, but following it.

A final thought on stops: Although there’s no concrete data available, trader superstition suggests that you never place stops at “obvious” prices such as $10.00, $25.50 or other round, commonplace numbers that are likely to appeal to the herd. The rationale? The public is lazy, so when Ma or Pa Kettle establishes a stop, you can bet it’s at $30.00, not $29.87. Because markets tend to cluster and churn where the herd’s stops rest, I try to pick slightly more unusual prices to avoid getting tangled up in the public’s clumsy tracks.

– Originally on Jan 24, 2005 by Jonathan Hoenig

Anybody can buy a stock. It’s how you manage the fallout that matters. Lots could happen: The economy could slump. Or interest rates could rise. The company’s sales could falter, or its CEO could get run over by a bus. This is the problem with following the fundamentals. It means concerning yourself with things that are far out of your control.

What really matters ultimately is the price action of the stock itself. When you buy XYZ at $50, there are only a few possible outcomes. XYZ could go up, down or go nowhere at all. We will briefly outline what I believe to be the time-tested rules for what to do next.

Let’s assume XYZ rises to $55, whether thanks to prayer, skill or just plain old luck. Even in a tough economy with soggy stock indexes, there’s always a bull market somewhere. You’ve got a winner on you’re hands, so forget the headlines. You’re up five points on XYZ…what’s your next trade?

The easiest, most appealing and seemingly safest follow-up would be to simply sell the stock. Heck, you made money on the trade! That’s the point, right? Take the profit and move on to the next big winner.

Not a chance!

It’s my sincere belief that whoever came up with the phrase, “You never go broke taking a profit” never had a profit in the first place. When a trade is going your way, do yourself a favor and don’t stand in its way. You can’t sell your winning stocks and expect to make money. I’m telling you because I know — that when it comes to the very basics of trading, that’s how you lose.

As psychologically difficult as it may be, when a stock goes your way, the technically preferable second trade would be to add on, ideally with a slightly smaller position. If you bought 500 shares at $50, buy 250 more at $55.

Sound crazy? There are plenty of traders who’ve never added to a position, and I think they’re missing the point entirely But if you liked it at $50, you should like it even more at $55. Because now $50 is just a pipe dream for those who weren’t as cunning as you. You’ve got a pair of aces. And regardless of what the headlines are, the price action is bullish. As a general rule, that’s about all you need to know.

There are only two times when you wouldn’t want to add to a winning trade. If adding to a position would significantly overweight your portfolio in XYZ, say over 20%, don’t do it. Also, watch the size of your additional buys. Just add to the position, don’t drown yourself in it. As always, trading isn’t about black or white, but shades of gray.

The other time when you might not want to add to a trade is if its move is accompanied by a great deal of public bullishness. Newspaper articles. Mentions on financial Web sites. Analyst recommendations. That sort of thing. You simply shouldn’t follow the herd. By the time most pundits pick up on a good idea, the real move has already been made.

A decidedly less exciting possibility is that, as hard as may be to comprehend, XYZ actually goes down in price instead. It happens. Minimizing losses is just as important as maximizing gains. So XYZ falls to $45. How should you proceed?

Assuming that it’s a strong stock — meaning a leading stock in a leading industry — and that my initial position was no more than 5% of my entire portfolio, I wouldn’t be too much of a hurry to cash out, even if XYZ did sink to $45 or go nowhere at all. So the second trade in this case might be a “nontrade.” A good old-fashioned hold.

The same thing goes when a stock just goes nowhere at all. It’s more than a little conceited to expect that XYZ is going to immediately bolt up simply because you or I bought a few hundred shares.

I’m not against holding onto a losing trade provided that you’ve invested only a small portion of your overall capital in it, leaving you free to move on to the next opportunity without totally abandoning hopes for XYZ. While there’s truth in the old saying, “Cut your losers and let your winners run,” sometimes you’re not wrong, you’re just early.

But how do you know when it’s time to reduce your position — or sell it entirely? Like most decisions in trading, this one essentially comes down to a question of asset allocation. When a losing position starts hurting an overall portfolio, cut the trade and move on. Or if you are overextended in XYZ’s sector or perhaps equities in general, don’t hesitate to reduce exposure, which is just French for taking a loss.

Maybe you take it all at once. Maybe you take half of your loss, or tax swap into a similar instrument, one simple way to maintain exposure to a particular sector while still grabbing a tax loss.

While it is our natural instinct to want to add to a losing position, I lost large sums of money before I realized that this is precisely the second trade you don’t want to make. Doesn’t matter what the headlines are, or how bullish the pundits are. When a trade is moving against you, it’s because you’re wrong, not the market. The best technique dictates that you take the loss and move on. Fighting the tape is a fight you will lose.

There are many ways to make money in the market, and ultimately every trader must develop a personal style with which he or she feel most comfortable. But I’m old fashioned, and while there are many reasons to get into a trade, in the most disciplined circles, there are only a few options for how to manage one. As in any art form, there is such a thing as classical trading technique. These are the rules, and although you never hear it discussed by the pundits or the chattering heads on CNBC, it’s the second trade (read: the follow-through) that really counts.

Whether it means mustering the courage to stick with (and add to) a winning trade or scaling back on the inevitable losing ones, sound technique is more fundamental to your bottom line than any financial statement or price chart will ever be.

– Originally on Dec 17, 2001 by Jonathan Hoenig

What messes most people up isn’t what to buy, but how. Having a good investment idea is a start, but putting it into practice is another thing altogether. And while a sound trading technique won’t prevent you from losing money, it will keep your losses small and the majority of your capital focused on the most profitable ideas. No trade is without risk, but the difference between risk and recklessness is proper procedure. Trading is like any fine art: There is such thing as objectively good form.

The oldest — and the only surviving — of the ancient Seven Wonders of the World are the Egyptian Pyramids. Their longevity is due, in part, to inherently strong design. The majority of a pyramid’s mass rests at its base, closest to the ground. A much smaller portion of the material is used near the top. The setup creates a uniquely stable architectural footprint.

What do pyramids have to do with portfolios? Just like the base of a pyramid, your initial position in a company should be your largest — depending on the volatility of the security and your tolerance for risk, anywhere between 2.5% to 5% of your portfolio. What stocks you pick matters less than the size of your commitments relative to your overall portfolio. If I’ve taken a position, it’s because I think it will become profitable. After all, if I’m not enthusiastic about my positions, then I probably shouldn’t have them in the first place. But no trade is without risk, so I need to be confident, not cocky. By limiting my initial purchase to no more then 5% of my overall portfolio, I am keeping the stakes relatively low. Even if XYZ goes to zero right after I’ve bought it (unlikely for most securities), I’ve lost only 5%. This way, you can afford to have bought the top (or sold the bottom) and still live to tell about it.

When you buy a stock, only one of three things can happen: It can move higher, showing you a profit; it can move lower, showing you a loss; or it can move nowhere in particular. As I wrote a few weeks back, most of trading is watching, not trading. So after I put on my initial position, I don’t listen to the pundits, but the market itself. I watch the action, not the analysts. A winning trade is usually profitable right off the bat.

But because I often am, let’s first assume that I’m dead wrong. I buy 100 shares of XYZ at $51, not knowing that it will prove to be the all-time top. The stock gets killed. First the company misses its earnings projections, then the top management leaves. Brokerages downgrade the stock and even loyalists throw in the towel. XYZ declines by 50%. I was wrong. Assuming I bought a 5% position, I’ve bought a 2.5% tax loss. My ego has been bruised more then my portfolio. I’d probably take the loss, revisit my analysis and keep watching.

What I won’t do, however, is something too many traders do: double down. If I buy 100 at $51 and 100 more at $26, I’m long 200 shares (now more than 10% of my overall portfolio) at an average cost of $38.50. With the stock at $26, it still has to climb 47% for me to get back to “even.” It could happen, but not without me putting an inordinate amount of my capital into a trade that isn’t working out to begin with. The point isn’t to be right, but to be profitable.

Conversely, let’s assume that my analysis was correct, and after I buy 100 shares of XYZ at $51, the stock moves to $52. I’ve got a winner on my hands, which is what we want. Ironically, it’s also where most people start getting into trouble.

Contrary to the trader stereotype, I’m not simply looking to buy before Regis and sell after Rosie. I don’t want to be in stocks for minutes, but months. So despite the human instinct to make the cash register ring when an initial position becomes even marginally profitable, it’s a sign to increase, not decrease, your exposure. When a stock moves up from your purchase price, it’s telling you something: You were right.

Most people cut themselves out of winning positions way too early because they want to feel good about having cashed a ticket. But the stock is not psychic. It doesn’t “know” I bought it down at $51. So if I’ve bought 100 shares of XYZ at $51 and the stock moves to $52, I’ll add another small position, let’s say 75 at $52. Now I’m long 175 shares, almost double my initial commitment, at a below-market average price of $51.42.

And if I liked it at $51 and $52, you can bet I’ll like it at $53. I’ll buy another 50 shares. And 25 more at $54. Add another 12 at $55, another 7 at $56 and so on. My position is expanding, but so are my profits. I am trading with the trend and focusing my capital on winning ideas. I’m riding the wave, not fighting it.

If the name of the game is “buy low, sell high,” you might ask why I don’t simply sell the stock as soon as it shows a profit and move on to another trade. After all, don’t traders buy and sell quickly, jumping in and out for the quick buck? As we all know, it’s tough to pick winning stocks. Many trades just won’t work out. So when I am fortunate enough to be right once in a while, my interest isn’t taking quick profits, but maximizing the earning potential of my positions.

With XYZ at $56, I’m up a little less than $4 a share on paper. But I’m really up more. Why? I’ve got a winner! I have a healthy-sized position at a low average price of $52.24 a share. XYZ has already trended higher and caught the interest of new longs. There are a million people thinking about getting long at $56. They’d love to trade positions with me and have bought a big block back at $52.

It costs money to get into a good position, namely commissions, time and the small losses you’ve taken on other trades. The point isn’t that every trade is a winner, but simply that your biggest positions are your winning positions. When you’ve got a winner, especially in a solidly constructed pyramid, you’re in a good position — don’t just give it away.

It’s a tough world out there, and only after leaving several quarts of blood on LaSalle Street did I begin to realize that good technique, namely money management, is what the game is all about. By staggering my purchases in a pyramid, I’ve bought comparatively few shares at the market’s current price, so even a sharp retracement back to 53 won’t knock me out of the game.

– Originally on Apr 19, 2001 by Jonathan Hoenig