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Friday, 10 November 2017
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Stop loss basics

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, who can be bothered?

And who can be bothered to be a trader 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.

But that doesn’t mean you 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 no long-term investor will either.

The big mistake for long-term investors is that they see things as being part of a portfolio in which the winners make up for the losers. And so they tolerate losers and leave them unattended. With that mindset long-term portfolio investors “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.

How do you cut weeds? Simple. Use stop losses. How? Let’s cut to the substance.

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. For those of us without trading systems you can use a number of different methods to set stop loss levels. 

  • Flat percentage: The most obvious stop loss mechanism 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.
  • 2% Rule: Most (hard core) 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.
  • 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 ypou bought it. This is a lot of manual work but there is nothing for nothing. If you constantly raise a stop loss as a share price rises 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 we use in the TRADING PORTFOLIO.
  • 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. So a volatile stock has a wider % stop loss than a boring stock. The way we'd 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 will tell you and you can set your stop losses a bit further out. And if you find yourself setting very wide stop-losses because of the volatility and you are uncomfortable with the loss the stop loss might imply then you are trading the wrong stock. 
  • ATR - Average True Range very brief explanation - If a 300c stock moves on average 10c a day 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 stocks 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.

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 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. Hard core traders use live 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 the article on the psychology of taking losses (click here). 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.

 

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