Repost How to set stop loss properly?

Dear Investors,
(e-mailed to investment class students on 28 August, 2006, contents exactly the same)

I received an e-mail asking about the Stop Loss. The question is:
"It seems that you would have very tight stop loss orders if you purchased the stocks that you mentioned (mostly 1-4%)"

My answer:
This is a good question, but in my previous e-mail, I only presented part of the story due to time constraint.

Let me elaborate more using 1088 as an example,

In my 16 August, 2006 e-mail, I said the following:
Closing price of 1088 on 16 August, 2006 is $14.18 (was 14.7 on 6 July, 2006, down 4%, if I actually bought it on 6 July, 2006, I would cut loss on 11 July, 2006 at around $14.595, lost less than 1%*). * This stop loss is calculated by my own program after the closing of 10 July, 2006.

In real life, I probably would have bought the stock on 23 June (see attached diagram) for 12.65 and my initial stop loss will be set at 12.30 (the BUY signal indicated on 21 Jun). A 0.35 loss (lower than 3%) will have minminal effect on my portfolio. Then according to my system, I will hold it comfortably until 11 Jul and sell it for 14.59 and take a 15% profit.

EVENIF I actual bought the stock on 6 Jul for 14.70, I will stop loss on 11 Jul for 14.59 and take a loss of 0.11 (less than 1%).

See, no matter what my purchase price is, my selling decision is EXACTLY the same! The market does not care how much I bought the stock for!

To go one step further, what if you refused to take profit (stop loss) on 11 Jul for 14.59? You will suffer a even larger loss in this case (13.45 on 18 Jul), the larger your loss becomes, the more difficult it is to stop loss (mentally)! I see many many cases like this, people continue to hold the losing stocks for years and hope that stock prices will eventually "come home"! Don't let this happen to you!

Eventually, everyone of you should develop your own system based on your risk tolerance, understanding of the stocks, and money management habbit. You can only make money when you have your own "system" (meaning: buying, selling, stop loss, profit taking rules).

Philip Wah

Disclaimer: The above discussions are for educational purpose only. Readers should perform independent analysis before investing their hard earned money!