Stop Losses Explained: Why They’re Essential for Every Investor
The Role of Discipline in Successful Trading
(Pulling The Weeds!)
Marcus Padley | 20 June 2024 | Education Corner
The life of a trader is not what most of us might imagine it to be – ie. glamourous, exciting and paved with gold.
More likely it is solitary, private, a bit boring, and when done right, provides a living. We could all be traders. We could all be Arnold Schwarzenegger too. Go to the gym every day, lift heavy weights, eat protein shakes, avoid chocolate, and talk in a vague middle-European accent. But the reality is, you need to be a little obsessed and quite honestly, most of us can't be bothered, because to do it properly is pretty much a full-time job, and most of us already have one of those, and those of us who don’t probably don’t want one.
I have worked with professional 'big book' daytraders, most brokers have them, trading with company money and the broker's 'edge'. It's not glamourous, it's stressful, it's unhealthy, it's boring. They usually trade just one stock endlessly, all day. One trader, one stock. We had a Telstra book, a Bluescope Steel Book, a BHP book. Some stocks had just the right amount (or lack) of volatility, to allow you to stack each side of the bid and offer and relentlessly take the spread. Exciting huh. Not.
Each trader when I was there was expected to earn $1m a year ($4,000 a day) and they took home 25% of that. The problem was that they could not leave the desk for a minute, and when aeroplanes hit a building, they could lose a year of gains (and their annual commission) in seconds. I don't want that job.
But that doesn’t mean we can’t adopt some of the core principles of the job, principles that apply not just to traders but to investors as well, principles like “preserve your capital” and “cut your losses”. Clichés all, but as any trader will tell you, no trading system will succeed without them and even a long-term investor will benefit from them.
The big mistake for long-term investors is that they see everything, as being part of a portfolio. But 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.
Long term investors with a "Portfolio Mindset" excuse the losers and do nothing about them. But if you really want performance the losers are just as importantas the winners and you need to protect against them. To do that you have to pull the weeds and plant flowers in their place. And if flowers turn into weeds, cut them and plant some more. Do this relentlessly and you will end up with a garden full of blooming flowers.
How do you cut weeds? The most obvious answer is to use stop losses
So let’s talk about 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: It is impossible to set a rule for everyone. There are many different types of stop-loss mechanisms but the principle of all of them is the same - Have the discipline to cuts losses and if you can't do that by feel, do it with a formula to circumvent your indecision and procrastination.
Here are some of the different methods to set stop-loss levels:
The most obvious is a flat percentage. If it falls by 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.
Most (hard core) traders use The 2% rule. The 2% rule means you are prepared to 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).
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.
Then there are rolling stop losses. As prices rise you raise the stop loss to guarantee a profit if the price then falls from its new high. This is probably the 'normal' approach. Adjusting stop losses upwards as prices rise and never adjusting them down.
Once in profit some people use partial stops, they continue to identify levels or technical sell signals and either sell all or part of the position depending on what level or signal is hit. So you might - Sell a third on a drop of X, sell a third on 2X and exit completely on a drop of 3X.
This is probably the best apporach and not as hard as it sounds - Using rolling ATR stop losses. This means setting stop loss levels with reference to the volatility of the stock most easily measured through ATR (see quick explanation below). Setting stop losses with reference to volatility allows the trade to develop without being stopped out by a normal fluctuation. Volatile stocks need more room to move. If you don’t understand volatility you are trading every stock as if it has the same risk, and clearly there is a big difference between trading Telstra and trading Elevate Uranium (EL8). More volatile stocks get wider stop l,osses. Boring stocks get narrower stop losses. Using ATR also allows you to do something called position sizing. This means using the volatility of a stock to determine how big a position to take. You can take bigger bets in boring stocks and you take smaller betrs in dangerous volatile stocks. Its logical. We'll look at position sizing in a another artice.
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 (how far it moved from top to bottom each day or week) over the last 14 days or weeks. A more volatile stock will have a bigger daily or weekly range.
To compare the volatility of stocks you then take the ATR and divide it by the share price to get a percentage that the stock moves on average every day or week.
The least volatile stocks are usually large listed stocks like TLS, NAB, COL, WBC, ANZ, CBA, ASX, SUN, CSL. You can see why richer income investors who want to protect capital and have a quiet life just hold banks. The most volatile stock at the moment in the All Ordinaries is CXO followed by SYA, IMU, WBT, BRN and 29M.
Knowing the ATR as a percentage of the price you can now set your stop loss - it is common practice to set a stop loss at a multiple of ATRs. Most commonly at 2 times 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. This is a chart showing the measurement of the average range.
People with a higher risk appetite and trading smaller positions might use 3xATR.
For more on this See our article on ATR - CLICK HERE
BACK TO STOP LOSSES ---->
Ultimately 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 have zero discipline, and when you do, set your stop-loss levels immediately on purchase, set them for each individual stock, keep them on a spreadsheet and update regularly (usually manually).
Stop losses are not a Golden Bullet, they are an "Alert". Something that taps you on the back of the head every time you open your spreadsheet that says "What are you doing?", "How long are you going to ignore this", "You've lost even more money", "Do something".
No-one is perfect. I know you will ignore your discipline, I know you will keep saying "I'll just give it one more day". And that's when you do something.
If you can be bothered read some trading books. It's a simple bit of logic and maths we should all know and it's stuff that you learn once that lifts you above the average punter in terms of trading discipline. Most good trading books are hard work (dull) and full of theory and interestingly have nothing to do with picking stocks. Its about risk management. It's not what you buy, it's all about what you do after you buy. That’s the bit that needs a plan and discipline and vigilance and where almost everyone goes wrong and doesn’t bother.
Of course, all of this stop loss stuff takes a bit of monitoring and this is where most of us fall down. But it is not as complicated as it might seem.
The Excel Spreadsheet
It's as simple as opening a basic excel spreadsheet. 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. When a share price drops below the stop loss you set it a 'tap on the back of the head' that says..."Are you going to do anything about it?". And when five stocks then ten stocks tap you on the head, you might just get the message.
Stop losses being hit and constantly ignored are a sign. A sign that you are either very rich and don't need to care about how much money you have, or a sign that you are inactive, indecisive, a procrastinator, and maybe shouldn't be managing your own investments. A sign that maybe you would be better off without an SMSF and with your money in an Industry or Retail Super fund instead.
If you are going to ignore the market's ups and downs and rely purely on the long term uptrend, why are you watching individual shares, and doing nothing? There are better things for you to be doing. Like life..and occasionally logging into your Super Fund website and checking they aren't completely cocking it up (which is something the big funds don't do).
Stop losses can still work for long term investors - One layer down from being in an Industry or managed fund is interested long-term investors who do manage their own shares. Your concern is Armageddon rather than a correction, but you can still use stop losses on that spreadsheet. Set your stop losses nice and wide 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. The average trader would check against daily closing prices. Other investors might check stop-losses against weekly prices. Whatever suits.
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 sell stocks that then go up again. You have to learn that once you've sold something you've executed a plan and what happens next doesn't matter. 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.
Taking losses delivers more than a financial value. It delivers a new state of mind, reduces stress, provides clarity of mind, empowers you to consider the next move unemotionally. And it lets you sleep at night whilst all around you falls apart. Cash is power, taking a loss puts you in the eye of the storm, a pause for objective thought. 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.
Stop losses are an idea, a discipline, not doing them automatically doesn't matter - best endeavours is good enough.
Prefer to watch? Check out Marcus' explanation.Marcus Padley
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I have worked with professional 'big book' daytraders, most brokers have them, trading with company money and the broker's 'edge'. It's not glamourous, it's stressful, it's unhealthy, it's boring. They usually trade just one stock endlessly, all day. One trader, one stock. We had a Telstra book, a Bluescope Steel Book, a BHP book. Some stocks had just the right amount (or lack) of volatility, to allow you to stack each side of the bid and offer and relentlessly take the spread. Exciting huh. Not.
Each trader when I was there was expected to earn $1m a year ($4,000 a day) and they took home 25% of that. The problem was that they could not leave the desk for a minute, and when aeroplanes hit a building, they could lose a year of gains (and their annual commission) in seconds. I don't want that job.
But that doesn’t mean we can’t adopt some of the core principles of the job, principles that apply not just to traders but to investors as well, principles like “preserve your capital” and “cut your losses”. Clichés all, but as any trader will tell you, no trading system will succeed without them and even a long-term investor will benefit from them.
The big mistake for long-term investors is that they see everything, as being part of a portfolio. But 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.
Long term investors with a "Portfolio Mindset" excuse the losers and do nothing about them. But if you really want performance the losers are just as important as the winners and you need to protect against them. To do that you have to pull the weeds and plant flowers in their place. And if flowers turn into weeds, cut them and plant some more. Do this relentlessly and you will end up with a garden full of blooming flowers.
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For more on this See our article on ATR - CLICK HERE
