Setting a Stop Loss based on Technical Analysis 

Tom Gentile

Posted in
Technical Analysis

By: Tom Gentile
May 26th, 2022

4 mins read

An integral part of trading, whether it be for a security or an option on that security is setting a stop loss.

A stop loss is an order to close sell a stock or ETF one may have purchased at a previous date and at a precious price.

If one is long a stock it means they own it and expect it to trade higher in price over time.

If one is short a stock that means they sold it/broker borrowed from another account for it to be sold and the short seller is expecting the stock to trade lower in price over time.

Sometimes Stocks Act Like Teenagers

There are times where some stocks, like a teenager just doesn’t do as you’d want.

For this piece we will discuss being long a stock, expecting a move higher in price.

Though, you’ve done your research, you feel you know the company and you anticipate strong sales and future good earnings and revenue growth, there are periods of time where a stock will not perform as you are expecting.

Now, you can’t discipline your stock or put it in a timeout or have it do yardwork to make good on its underperformance like you could your teenage child, you can decide if it is worthy of keeping.

No, we are not talking about you getting rid of your teenager, but rather getting rid of the stock in your portfolio.

If you use or used some form of technical analysis in your decision to go long a stock.  If it comes to a point where it breaks that technical pattern or price goes to a place where the technical pattern is deemed broken, it may be time to stop out of or sell that stock out of your portfolio.

Further discussion should be had with your broker as to the stocks worth to the portfolio and if it is better to part ways with it or not.

Technical Stop Loss

We will get in to future lessons about Stop Loss vs. Stop Limit, but for now I want to focus your attention on a technical view that may help you decide to part ways with the stock.

To iterate, a Stop Loss is an order to stop out of the stock or stop the losses being realized by owning the stock.  And that stop loss can be based on a price in the stock or a percentage drop in price / value in that stock, e.g., stop loss of 50% means if the stock drops 50% of its original purchase price stop out or sell that stock and move one.

Support and Resistance

A support is hat we will discuss as the scenario we are talking about is for a person who owns the stock long, expecting a higher price move.  Rather than set an arbitrary percentage stop loss, one can consider using some technical analysis to assess where they will stop out of the stock.

Image
Figure 1: SPY with a Deemed Price Support

In the chart image above on the SPY, we are highlighting what may be a support price area on the index ETF.

Support is a price on the chart where the price of the security goes to and gets ‘supported’ from falling any further.

When a stock breaks that support for 1 or more days, one may see that as the technical basis for the ownership of the security is broken and it is time to move on.

If one owns an option on the SPY, they would consider placing what’s called a Contingency Order on the option.  That means one would want to stop out of the option trade contingent the SPY breaking that support price.

Another lesson for another day.

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