Cut Some Losses At Even Less Than 7%-8%



Posted 6/24/2008
If you were betting on horses and the bookie allowed you to have your money back after you saw your horse stumble out of the gate, what would you do?

You'd get your money back. Sure, the horse might come back and win, but with a bad start, the odds are stacked against it.

Stocks are no different, except that you cut your losses short. The basic rule: Sell any stock that falls 7% or 8% from the price at which you purchased it.

But you don't always need to wait for a 7% loss if a breakout starts acting more like a fake-out.

Don't be afraid to cut losses at 5% or even 2% if a stock isn't acting right within a week or two after its breakout.

Of course, to do this you need to recognize the signs of a faulty breakout.

About 40% of market winners slip back to their buy points but still go on to major gains. But watch out for these signs of a failing breakout:

• The stock starts dropping in heavy volume, perhaps undercutting its 50-day moving average.

• The Relative Strength line lagged the stock price at the breakout.

• Volume on the breakout was less than 50% above the stock's average daily turnover.

• There's bearish action, such as a price reversal, failure to make new highs or a large gap-down in heavy volume.

Don't forget a basic tenant: the market's direction. If the general market is faltering, selling before incurring a 7% loss is often wise.

Any of these red flags takes on greater significance if the base had flaws, such as too much distribution (i.e., more down than up weeks in above-average volume) or a pattern that was too deep (more than 35%, generally).

Investors who could spot such weaknesses would have saved themselves from losses in InnerWorkings (INWK) in July 2007.

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