From the July 01, 2011 issue of Futures Magazine • Subscribe!

Six tips for trading stocks in volatile times

2) Unwind right: To achieve your desired cash level, start by converting any margin positions to fully funded and selling losing or laggard positions. Losing stocks are a drain on the portfolio. They not only affect your mental psyche (no one likes logging in day after day and seeing red), but also are more at risk for further declines if the market should struggle. By holding onto the absolute best positions both fundamentally and technically, you give your portfolio the best risk-to-reward moving forward. For the investor predominantly trading equities, this is as easy as placing several market or limit orders.

3) Manage your winners: If you have sold your losing positions and still are not at a desired cash level, trimming exposure in winning stocks is the next course of action. Arguably, the toughest decision any investor ever will make is deciding when to sell shares of a profitable investment. It is never an easy call. So, instead of completely selling off one or more of your top holdings, try liquidating 25%-50% of several winners and converting those unrealized gains to locked-in profits. This way, you still maintain a broader exposure with your best stocks while accomplishing the task of raising cash for your portfolio.

Insurance matters

With your portfolio’s exposure to the market aligned with your current confidence, you can zero in on managing your freshly trimmed portfolio by adding extra protection against the downside using stops.

4) Limit losses with stops: Stop-loss orders can serve as great protection against the downside when used properly. They remove the psychological battle of deciding on the right time to sell and help maintain a disciplined approach to the market.

A stop-loss order is like taking an insurance policy out against your position. If an investor holds 100 shares of company XYZ at $100 per share and they don’t want to lose more than 10% of their investment, they can place a stop with a trigger price of $90. This will automatically sell their shares if XYZ falls below $90 (10% of $100) at any time in the future.

The only event that can prevent their stop order from limiting their loss as intended is if the stock trades through their trigger price with a gap move. For example, if stock XYZ reports earnings and falls to $85 in after-hours trading, the stop order would not have triggered at $90, and the investor would be forced to sell their shares on the open market the next day. Traders always should work slippage into their calculations when setting stop levels.

5) Tighten stops in risky markets: Stops are particularly useful in tough markets because false breakouts and reversals are common. For traders who like to buy stocks on breakouts, setting a tighter stop of 3%-5% vs. the traditional 6%-8% can minimize losses. Take, for example, Google (GOOG), which had a short-lived breakout in January of this year (see "Short-lived gains," below). After basing out over a two-month period, Google made a push to fresh three-year highs above $631. Unfortunately, two of the next three days were heavy distribution days, and the stock collapsed back into its base.

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False breakouts like this are extremely common in downtrending markets and prevalent in sideways markets where bulls and bears fight over future direction. In a smoothly uptrending market, it’s fine to employ looser stops, but when navigating uncertain markets, tighter stops can keep a portfolio afloat and moving forward.

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