Setting stop-loss and
take-profit points is often done using technical analysis, but fundamental
analysis can also play a key role in timing. For example, if a trader is
holding a stock ahead of earnings as excitement builds, he or she may want to
sell before the news hits the market if expectations have become too high,
regardless of whether the take-profit price was hit.
Moving averages represent the most
popular way to set these points, as they are easy to calculate and widely
tracked by the market. Key moving averages include the five-, nine-, 20-, 50-,
100- and 200-day averages. These are best set by applying them to a stock's
chart and determining whether the stock price has reacted to them in the past
as either a support or resistance level. Another great way to place stop-loss
or take-profit levels is on support or resistance trendlines. These can be
drawn by connecting previous highs or lows that occurred on significant,
above-average volume. Just like moving averages, the key is determining levels
at which the price reacts to the trendlines, and of course, with high
volume.
When setting these points,
here are some key considerations:
- Use longer-term moving averages for more volatile stocks to reduce the chance that a meaningless price swing will trigger a stop-loss order to be executed.
- Adjust the moving averages to match target price ranges; for example, longer targets should use larger moving averages to reduce the number of signals generated.
- Stop losses should not be closer than 1.5-times the current high-to-low range (volatility), as it is too likely to get executed without reason.
- Adjust the stop loss according to the market's volatility; if the stock price isn't moving too much, then the stop-loss points can be tightened.
- Use known fundamental events, such as earnings releases, as key time periods to be in or out of a trade as volatility and uncertainty can rise.
