HOW
TO EFFECTIVELY USE STOP-LOSS
Almost every
person loves to take profit but if things go contrary to his
expectations, he must also use a Stop-loss to limit his losses.
Question is how much loss is enough? There is no clear answer
to this question that will suit every trader's needs and circumstances.
If one does not want to lose a great deal, he should keep the
Stop-loss close to his trade price. The benefit is a small loss.
However this would increase the probability of the Stop-loss
being triggered. So the result is small but frequent losses.
On the other hand, if a trader does not want his Stop-loss levels
to be frequently triggered, he should keep more distance between
his entry price and the Stop-loss. This will result in less
frequent but higher losses. So how much loss is ideal? It is
really an individual's decision based on his risk-tolerance,
asset base, trading system, return objective in the position,
market conditions and the nature of the stock itself.
So
how much is enough?
One should look at the stock's price, volatility, current market
conditions and return expectations to determine an efficient
loss/risk amount for him. For an average individual, it could
be from 5% to 25%. For a 5$ stock, with high volatility and
expectations for 100% return over the intended holding period,
it could be 25% of the amount invested. This means if someone
buys at 5$, Stop-loss could be kept at 3.75$. In the opposite
extreme, for a 120$ stock with average volatility and a target
return of 30%, the Stop-loss can be placed at even as low as
3%. As this kind of Stop-loss will protect one from big unexpected
losses, they are frequently called as Protective Stop-loss.
What
should be a base/price level to calculate our stop-loss?
Let us assume
that 5% is the ideal Stop-loss or safe distance percentage for
a given position. Now another question is what level one should
use to calculate his Stop-loss price. If he buys this stock
at 50$, the most obvious choice is to use the 50$ level and
go for a safe distance of 5%. This will be 47.50$. This is the
most widely used approach to determine Stop-loss levels- to
use the purchase price as the base price.
However
John Magee in his classic book on Technical Analysis of Stock
Trends (a must-read for chart reading investors) suggests
using Minor Tops and Minor Bottoms as base points. It
makes a lot of sense. An individual's purchase price has no
meaning in the universe of constantly fluctuating stock prices
but Minor Bottom/Minor Top is a somewhat significant price level.
Minor bottom is the price point where at least for some time
buyers were more aggressive than sellers and were able to push
prices higher. Minor bottom means buyers' gained more strength
to outbid selling pressure. Similarly a Minor Top the recent
high price. It is the price at which the stock attracted more
selling.
How to
decide a minor bottom?
It is tricky
and subjective. Different people can have different methods
or parameters to find Minor Tops and Bottoms. Here also, I like
John Magee's definition.
Let me try
to explain a Minor Bottom:
- Suppose
prices are going down for a stock for some time (how much
is some time? It could be 2, 3 or more days. One can pick
his own number and fine tune it as he gains trading experience.)
- The
stock price makes a low of 45$ on day X. The high on that
day was 48$.
- Let us
call this high price (48$ in this case) on the low price day
(X) a Key Price. As soon as there are three consecutive days
on which stock does not trade below this Key Price (48$ in
this example), the low price of day X will become a Minor
Bottom (45$ in this case).
The same
thing can be applied in reverse for calculating a Minor Top.
Read this again and again until you comfortably understand it.
Thus for best results, one should use the Minor Top or Bottom
as his basis to calculate Stop-loss level for his position.
This is likely to provide better protection than the stop-loss
calculated based on his entry/trade price.
PROGRESSIVE
STOP-LOSS
Stop-loss
is mostly referred to a loss situation. This should not be the
case. Stop-loss can also be used to a trader's advantage in
a profitable trade when prices are moving the direction he wanted
them to. A Protective Stop-loss level can be changed in the
direction of the stock price. If one has taken a long position
and the prices are going up, he can increase his stop-loss level.
This makes it a Progressive Stop-loss. (The word "Stop-loss"
word becomes deceptive in this context. Instead of relating
to a loss, it is used to protect a profit).
Let me explain
a Progressive Stop-loss in more details. Let us continue our
example above. Assume that the trader bought the stock at 50$
after a Minor Bottom was confirmed at 45$, and kept a stop-loss
with 5% distance which is 42.75$. This is the initial Protective
Stop-loss.
Assume that
the stock price goes up and touches 55$ and then enters into
a reaction and slides back to 50$. The day it touches 50$, the
high was 52$. Now again the price seems to be going up and there
were three consecutive days on which stock traded above 52$.
This will confirm a higher Minor Bottom at 50$! Now he can raise
Stop-loss to 47.5$ (50$ minus 5%) from initial level or 42.75%.
Assume that
the stock resumes it up-trend and makes a higher Top at 65$.
Then it slides back to as low as 58$ and passes the 3-day test
of a Minor Bottom. So now one can raise his Stop-loss to 55$
(58$ minus 5%). This trading position is in profit now and profit
is also sort of guaranteed! Say the upward trend in prices of
this stock continues. It touches a price as high as 85$. Subsequently
let us say a Minor Bottom is confirmed as per our three consecutive
days test at 78$. So the new Stop-loss level is now at 74$ (78
minus 5%).
Now let
us assume that after the last Top and Bottom being confirmed
at 85$ and 78$ respectively, the stock fails to go higher than
85$. This is an indication of some weakness. Now when it starts
going below 78$ (the last Minor Bottom), one should get worried.
Still there is no need to sell the position because the stop-loss
is 5% below the last Minor Bottom. This helps us if the stock
is forming a mid-trend pattern like flag or pennant. If after
going as low as 75$, the stock resumes its upward trend and
goes above 85$, one is still in the game! However if it does
not go higher and instead goes below 74$ (current Stop-loss
level), one should close the position. As you can see, even
if the stop-loss triggered, the position had a profit of 24$
(Sell price 74$ versus purchase price of 50$) per share!
I hope above
description about Progressive Stop-loss makes sense to you. Here
is one real example:
This is
the Chart of BRCM (Broadcom Corp)- a one-way superstar, during
2002. Around that time, I was watching it closely. It was drifting
from 40$ down to less than 20$ but did not confirm any Minor
Bottom on the way according to the 3-consecutive-days test.
Ultimately it touched 18.40 and then later on, on 3rd, 4th and
5th day it passed the 3-day consecutive rule! It formed a Minor
Bottom as marked on the Chart. It was a buy signal for the first
time and one could have bought it for around 25$. Initial Protective
Stop-loss would be at 16.50$ (18.40$ minus 10%) allowing a loss
potential of 8.50$/share!
The next
Bottom -- Bottom2 -- was confirmed at 27.50$ which would bring
the Stop-loss to 25.00$ (27.50$ - 10$). Then it made another
higher Minor Bottom -- Bottom3 -- around 33.00$ bringing the
Stop-loss to 30.00$. At the time, the Chart was drawn, BRCM
stood at 45$. At that time, one could have booked profit of
20.00$ or like an astute trader, he could have held on to it
with a 30.00$ Stop-loss and raising it progressively higher
if the stock continued to confirm new higher Bottoms.
