Beginners Education: How to set Stop Losses

I was on the golf course one weekend with a chap called Simon who mentioned a few stocks he has held that initially did very well but he now (July 2021) held at a loss. MEZ, NWH and ORI.

Simon has no post-purchase discipline/mechanism. Time for a lesson in stop losses.

Investment is not about “forever” as the Buffett quoting automatons suggest. It is about making money in any stock, on any time frame you can, long or short. Of course, every investment starts out in the hope it will be a long-term investment, and if the stock keeps going up forever it will be a long-term investment. But what if it doesn’t? What if the initial decision to invest was a mistake? Do you deny it, stick to your guns, do a lot more work to cover up the error, and proudly stand by your stock come what may? Of course not.

You can do all the research you like, narrow the odds as much as possible, know everything, but unfortunately, sometimes the stock market doesn’t do what you want. Sometimes the stock price doesn’t behave, sometimes the market doesn’t behave (and sinks all ships whatever the individual merits). All companies go through cycles, the stock market goes through cycles, the facts change, the initial assumptions change, so the decision to hold it has to be able to change.

One of the worst traits of individual investors is the inability to sell. It comes from taking the stock market too seriously. We all need to relax and see the stock market, even as a non-trading, income-focussed, conservative investor, as a means to make money, not a relationship that you can’t cheat on.

You have to use the stock market, not allow those useless human traits of loyalty, pride, prejudice, and denial get in the way. You have to be Spock. Cold, logical, unemotional, and focussed on the goal whatever that is (make money, enjoy a hobby, engage yourself intellectually, meet people, do interesting things, exercise the mind), and one well-worn way to combat the inability to sell and the invasion of human weakness, is to use stop losses.

STOP LOSSES

What are they? An order that automatically closes your trade at a predetermined price, thus limiting your loss. A stop loss is a mechanism that short-circuits debate and emotion and provides certainty.

Requirements - Forget the concept of “portfolio”. Think of every stock you hold as a separate trade. Preset a stop loss for each individual holding, preferably when you are unemotional and in possession of a clear mind. The time of purchase would be good but any time will do.

The mechanism: You can use a number of different methods to set stop-loss levels. Whatever suits you.

• Flat percentage: The most obvious stop-loss mechanism is a flat percentage. If it falls by (say) five per cent, sell it. But that’s very basic and most of us struggle doing that in practice. The market is so volatile these days.
• 2% Rule: Most (hardcore) traders use something called the 2% rule – that is to say they risk a maximum of 2% of their trading capital on any one trade. In other words, on $100,000 of capital (a portfolio of $100,000) they would cut a trade that makes a $2,000 loss. Notably, this is not the same as a 2% drop in share price. If they have put $10,000 of the $100,000 portfolio in the trade it could be a 20% loss on that one trade ($2000 of the $10,000).
• Lines on charts: Another way is to set stop loss levels is by reference to a chart rather than a percentage. For instance, if you are trading price breakouts (buying stocks that break a resistance level) the stop loss can be set at the price at which it breaks out and so the resistance level that was broken serves as the stop loss level if it reverses again. Or if you are in a stock that is trending up in a trading range you sell it when it breaks the uptrend support line at the bottom end of the trading range. You need to be a bit charty for this but it is often one of the most obvious methods – selling on a change of trend.
• Rolling stop losses: Perhaps the most popular stop losses are rolling stop losses. As prices rise you raise the stop loss to a set percentage below the highest high since you bought at. This is a lot of manual work (updating the stop loss daily to remain x% below the high) but there is nothing for nothing. If you constantly raise a stop loss as a share price rises (and never drop it) then you eventually get to a point when the stop loss is above the entry price and you are (subject to gapping) guaranteed a profit on the trade. This is what most traders use.
• Volatility based stop losses: You can also set stop loss levels with reference to the volatility of the stock. This involves setting stop losses at a level that allows the trade to develop without being stopped out by a normal fluctuation (it's stopped out by an abnormal fluctuation). So a volatile stock has a wider % stop loss than a boring stock. The way you do this is by using average true range (ATR - see definition below). Simply put this allows you to account for how volatile a stock is when setting a stop loss. Volatile stocks need more room to move. If you are trading a volatile stock then the ATR as a percentage of the share price will tell you how volatile it is and you can set your stop losses a bit further out. And if you find yourself setting very wide stop-losses because the stock is very volatile, and you are uncomfortable with the loss the stop loss might imply, then you are trading the wrong stock.

ATR - Average True Range- a very brief explanation

If a 300c stock moves on average 10c a day (the average range from top to bottom it has traded in each day for the last 14 days) then 10c is its average true range. You work that out by averaging the daily share price range over (say) the last 14 days or weeks. A more volatile stock will have a bigger daily or weekly range. You can then use that to set your stop loss - it is common practice to set a stop loss at a multiple of the stock's range. Most commonly at 2 times the daily range or 2x the ATR from the purchase price. So for our 300c stock with an ATR of 10c, you would set the stop loss at 2xATR below the share price, which is 280c. For a 100c stock that moves 5c a day your stop loss might be set therefore at 90c. This would be your initial stop loss. You might then roll that price up as the share price rises so the stop loss is constantly 2xATR below the highest price hit since the trade was placed. You can get ATRs for all the top 500 stocks on a daily or weekly basis from the Marcus Today ALL ORDINARIES SPREADSHEET. This is a chart showing the measurement of the average range.

BACK TO STOP LOSSES

There are a lot of ways of setting stop-loss levels. As noted, a flat percentage is very basic. But the core to it is to make the decision to use them rather than rely on guts, set your stop-loss levels early, set them for each individual stock and stop thinking in terms of “the greater portfolio”.

Of course, all of this takes a bit of monitoring and this is where most of us fall down. But it is not as complicated as it might seem.

All you need do is get a list of your stocks, a list of current prices and next to that a column defining your stop-loss levels. Every so often update the current prices and compare to the stop loss price and adjust stop losses to account for any share price rise (never move them down, only up). It’s that simple.

If you consider yourself a long-term investor and your concern is Armageddon rather than a correction, you can be a bit relaxed. Set your stop losses nice and wide (10% plus) and update current prices once a month or whenever the news “vibe” suggests something could be going wrong. Dance to your own tune.

If you are more concerned about short-term fluctuations check in more often. Hardcore traders use live prices. A day trader would set stop losses using the intraday prices. The average trader would check against daily closing prices. Other investors might check stop losses against weekly prices. Whatever suits.

But the main thing is to pay at least some attention to what’s happening and have an understanding with yourself that you will take action when a price falls a pre-determined amount, and stick to your guns.

If you work stop losses diligently then when the market falls over you will find you have sold each stock on its own lack of merits as it turned down and have ended up in cash, where you should be, without having to make some impossibly big call on all your holdings (your portfolio) at once.

Yes, you will make mistakes. Yes, you will sometimes sell stocks that then go up again. But nine out of ten stocks that are going down are going down for a reason and are likely to keep going down. And if they don’t, don’t worry about it. The game is to learn what works and whatever you do it has to be better than setting and ignoring.

Have a read of this article on the psychology of taking losses. It will tell you that "Cash is power". Taking a loss puts you in the eye of the storm, gives you clarity and you know, you can always buy back.

This is a huge subject to consider so let me leave you with a core tenet: When it comes to controlling losses anything is better than nothing – and if your mechanism doesn’t work, you can always change it.

EXECUTING STOP LOSSES

Most online brokers allow you to set "Contingent Orders"...if the price does this do that. But you don't have to operate stop losses online, you can still do it yourself on paper and just execute manually when the time arrives.

Full-service brokers will not operate stop losses for you. You can still do it through the broker but they will all tell you "We don't do stop losses". This is because as a full-service broker they don't have the computer mechanism to operate stop losses automatically - they trade manually. If they promised to monitor and execute a stop-loss their only option would be to watch the screen 24/7 and operate an order if your parameters are hit. But that's not practical - a computer can do it but a human can't. If they pop to the loo or out to lunch and whilst they're not watching the parameters are hit and they miss selling, you can sue them for missing it - so they'll never promise to operate a stop loss for you. No full-service broker will promise to do that. So they just say "We don't do stop losses".

But that doesn't mean you can't watch them yourself and when a stock hits your stop-loss level you just ring up and say "It's hit my stop loss can you sell it for me". The broker will be more than happy to do that for you. But it means you have to watch it, because the broker won't/can't.

CommSec and a few others allow contingent orders ("If the price trades at X sell it") but you don't need to be online to have a stop loss discipline. Just do it manually. You can still tell your broker what levels you have as stop losses, and they might remember to ring you up and remind you, but they won't promise to do it for you because if they did there is too much room for error and they understandably don't want to be held liable and be sued.

Stop losses are an idea, a discipline, not doing them automatically doesn't matter - best endeavours is good enough.