How to Use a Stop Loss to Limit Your Downside Risk

If you’re trading penny stocks, it’s important to understand the benefits of setting stop losses to limit the downside on your trades. When you learn how to set up a proper stop loss, you can avoid holding onto a failing position due to purely emotional reasons. And by cutting your losses at the correct time, you can drastically improve your portfolio. Today, I’m going to show you exactly how to do just that…

Take a look at the chart below (the name of the stock has been redacted—it’s not important for our discussion):

In this example, let’s say you entered a position in the stock at $1.09. You’re hoping the stock is able to break through resistance at $1.15. But you also want to protect yourself should the stock break its trend and move lower.

That’s where the stop-loss order comes in. A stop loss is an order with your broker to sell your shares in a particular stock automatically when its price hits a specific level. That means if your shares of Stock A are up 30%, you can set a stop loss to trigger when the stock drops to 25%, guaranteeing your minimum profit. And when you’re entering into a new position, like the one above, placing a stop loss guarantees that you won’t be bleeding red ink if the trade goes awry.

Here’s how it works: I drew the horizontal blue line through recent areas of support and resistance. If you look toward the earlier dates on the chart (October, November, December), you will see similar points of support at 60 cents, 75 cents and 90 cents, respectively. Resistance is at 70 cents, 85 cents and $1.05. It’s not perfect, but rather a general area where a stock encounters a bit of a speed bump in its movement in either direction.

Now let’s apply support and resistance to stop losses. We don’t want the stock to break its uptrend. The stock has been bumping its head on $1.15 since December, and we want it to break and hold this mark. And we don’t want the stock to break support of $1.05.

If you prefer a tight stop loss, set it at $1.05. That is, if the stock closes below the $1.05 mark, not if it merely breaks the $1.05 mark in intraday trading. If you want to give your trade a little more breathing room, you might want to consider the all-important $1 mark as your stop.

Of course, you can revisit your stop loss if and when your stock moves up. That’s why you need to continue to monitor the position, updating your stop loss as the trade progresses. When the stock finds a new point of support, reset the stop loss directly below the new support. If it breaks the mark, sell and take your gains off the table.

As I mentioned above, the stop loss helps protect investors against their own emotions. Wanting a stock to go up—and the stock actually moving in the right direction—are two very different things. All to often, investors will hold onto their losing trades much longer than they should. These losses will eat away at all of your profitable trades, potentially causing you to make increasingly risky bets to make up the lost ground.

Simply put, it can be a recipe for disaster.

But, of course, stop losses only work if you set them and stick by your decision, selling if and when the time comes. Constantly second-guessing the market is another big mistake that can spell doom for your portfolio.