How to Set Stops and Protect Your Portfolio

by Darrin Donnelly on November 16, 2010

How to protect your money when a trade goes against you.

How to protect your money when a trade goes against you.

Before initiating a trade, you need to know what your “worst case scenario” stop will be. 

You have to have an answer to this question: “If this trade goes against me, where will I cut my losses and exit?”

Every successful trend trading strategy has a built-in initial stop rule for protecting your portfolio from heavy losses.  This rule simply states that no matter what, this is the MOST you can allow a position to go against you.  The Darvas System is no exception. 

One of the more popular initial stop rules comes from Investor’s Business Daily founder (and Nicolas Darvas fan) William O’Neil.  O’Neil advises readers to set an initial stop 8% below the buy point of every new stock purchase.  This means that, WITHOUT EXCEPTION, a stock should be sold if it falls 8% below the point where you bought it at.

In general, a simple 8% stop is a great idea.  Nicolas Darvas himself recommended a 10% initial stop on every trade made.  Jesse Livermore and Gerald Loeb also recommended cutting losses at 10%. 

However, I prefer to use technical points to set stops (especially if we’re buying out of a base that may be a bit short or shallow).  

I find percentage-based stops to be a bit arbitrary because each stock is different.  While an 8% drop in one stock might be an enormous and alarming move, an 8% drop in another stock may be quite typical and even constructive for that particular stock’s high-beta behavior. 

Another problem with a strict 8% or 10% stop rule is that many professionals are aware of it and can therefore use it to cash in on quick profits and create “false moves” for a stock. 

For example, if a few hedge funds think that thousands of independent traders have placed a stop 8% below a breakout point, they may try to short the stock down to that level in order to trigger thousands of stops and book a quick profit.  After which, the stock often rebounds.  Such action is extremely frustrating for an independent trader.

With this in mind, I think Darvas traders are better served with technical-based stops in today’s market environment.  This usually means setting stops either at the midpoint or at the bottom of the base the stock is breaking out of. 

As a rule of thumb, a standard long and deep base should have a midpoint stop.  A short and shallow base should be given more leeway, with the stop placed at the bottom of the base.
 
Using technical-based stops like these means that we will often allow stocks to fall more than 8% below the buy point, sometimes 15%-25% or more.  For this reason, you need to adjust your initial position size in order to alleviate the risk to your portfolio (I recommend using the 2% Rule explained in my book, Secrets of the Darvas Trading System). 

Or, when the situation presents itself, you can use the more advanced technique of making smaller “pocket” purchases in order to lower your cost-basis if/when a breakout does occur.
 
In short, I prefer to pyramid into rising stocks, which allows me more leeway on the initial breakout, as opposed to buying large positions on a breakout and then following a strict 8% or 10% sell rule.

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* Portions of this article appeared in the November 10, 2010 issue of Darvas Trader PRO.  You can try Darvas Trader PRO risk-free for 30 days by clicking here.

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