Stops For Safety

Despite ill-fated investment moves and wild market fluctuations, you can stay in the game if you actively manage your money. You are not at the mercy of the markets; the amount of risk you accept is under your control. Here's a simple money management technique  you can use to assess risk and protect your capital from possible losses.

How much risk can you take?
There is an element of risk in every investment decision you make, though the degree of risk may vary. Before I invest, I quantify my risk by determining:

1 How much money I am willing to invest (investment capital), and
2 How much of my investment I am willing to lose (risk capital).

RC = IC * LT

Where:
RC = Risk capital
IC = Investment capital
LT = Loss tolerance, or the percentage of investment  capital I am willing to lose

RC = $5,000 * 0.15
      = $750

This price actually works out well. Coincidentally, the stock price chart of IBM in Figure 1 shows that in the last couple of months, the price did not fall below the $87 level. In technical analysis, this is known as a support level -- a critical point. Buyers and sellers struggle to keep prices above this level because a drop below it would mean that prices could go much lower.

FIGURE 1: INTERNATIONAL BUSINESS MACHINES (IBM). A strong support level is evident at $87, which suggests that to minimize losses, I should sell my shares if prices fall below that level.

Because I identified the $87 support level on the chart, I decided to be a little more conservative in my risk tolerance. Instead of $85, I chose $87 as my threshold. If prices fell below $87, I would sell my shares in Ibm. I would place a stop order with my broker at $86.875, just below the $87 support level. A stop order is a type of order in which you instruct your broker to sell your stock when the price reaches a specific point.

CONCLUSION

By having your entry and exit strategies in place before jumping into any investment, you are protecting yourself from possible major market downslides and minimizing your risks. Not only that, but if you are unable to monitor your stocks for any reason, placing a stop order ensures that when prices do reach your risk tolerance level, your securities will be sold. With the way the market has been behaving of late, this may be one of your wisest decisions.

Source: MetaStock
(Equis International)
Data: eSignal