One important dimension of any trading system is the ability to
keep losses small. This is most of the times achieved with the
use of STOP-LOSS. So let us spend some time to learn what a Stop-loss
is and how one can use it in trading to his advantage.
Stop-loss
is a widely used term in investment circles. As the name says,
it is a price level at which one should stop or limit his losses
in a position. Investing or trading is like gambling when one
looks at from the outcome perspective. When a person gambles
or speculates, he does not know what the outcome will be. He
would hope the outcome to be in his favor but it could very
well go against him. The same thing goes for investing or trading.
When someone buys a stock, he might be thinking, and to a great
extent hoping, that the stock price would go up, but it could
very well go down. So what should a person do if the prices
go contrary to one's expectations?
There are
two alternatives: (i) He can continue to hold it believing,
and hoping, that it will ultimately go up; or (ii) He can blame
the unexpected mess on his wrong selection, bad judgment, bad
timing or on circumstances/development beyond his control or
imagination, and… get out of the position.
INTRODUCTION
TO STOP-LOSS
It is a
price level or a mechanism that forces a trader to take/book
losses in a losing position instead of letting them grow any
bigger. Ideally a Stop-loss level should be decided as soon
as a trade is executed. If a stock say ABC is bought at 25$,
Stop-loss for it can be kept at a price level somewhat lower
than 25$. It can be 24, 23, 20 or even 15$. Let us assume the
Stop-loss is kept at 20$. This means if the price of ABC, after
having bought at 25$, goes below 20$, one should close the position
by selling it. 5$ is the loss the buyer is limiting to. This
might be little confusing for novice traders because it involves
closing a position willingly at a loss! Remember: In a long
position, the Stop-loss level is usually lower than the entry
price.
Likewise
if a person Shorts (what is this term? It means sell first even
if you don't own the stock with the hope to buy it back later
at a lower price) ABC stocks at 25$, he should keep a Stop-loss
at any price higher than 25$. Say if it was kept at 30$, this
means if the price moves up contrary to the initial expectations
of it going down, and touches 30$, one should call it a quit
and square up the position. Thus, in a short sell, the Stop-loss
price is higher than the price at which the stock was sold.
COST
AND BENEFIT OF USING STOP-LOSS
The use
of Stop-loss has its merits, and problems too. Let us take two
examples to illustrate cost and benefit of it.
Let us assume
someone bought a stock like, CMGI or ARBA, around 150$-level
during the Year 2000 boom period, thinking that it was a great
company (Believe me there were many investors who believed so
at that time!). And if he continued to hold to that position
during its downtrend (hoping that it would one day reach 200$!!!),
he would have seen the stock price drop to as low as 1$ in 2002!
In this kind of situations, one would wish if he had kept a
Stop-loss and limited his losses to 5 or 10$ per share! This
makes a strong case for the use of Stop-loss.
Now let
us look at an opposite situation. Assume that the same person
had bought Yahoo at split adjusted 10$ in October 1997 and kept
a Stop-loss at 9$. Suppose the price went below 9$ and triggered
his Stop-loss. He would be out of Yahoo! Position at a 100$
loss! Then as time passed, Yahoo kept climbing up and ultimately
reached as high as 500$ in January 2000! An initial 1,000 $
investment could have been worth 50,000$ if there were no Stop-loss
were used!
Should
A Trader Use Stop-loss?
So a million
dollar question is: Should you use Stop-loss or not? Answer
is that it depends. If you are an investor with purely long-term
perspectives and with a diversified portfolio, you should probably
not.
As the saying
goes, there is no free lunch in financial markets. So the use
of a Stop-loss has its benefits and problems. In a few paragraphs
below, I will try to show you how to get the maximum out of
this Stop-loss and how to use it in your favor. Let us go back
to the above two scenarios one more time.
Let us assume
that that 1000$ position in Yahoo at 10$ price had no Stop-loss.
Do you think the buyer would have continued to hold onto it
until it touched 500$? It is very likely he might be out before
it even doubled or tripled! I think most of the investors including
myself would be pretty satisfied to have doubled or tripled
our investment over a short period. Let us assume our buyer
of Yahoo in this example is made of different material. Suppose
he had guts to hold on to a winning stock and he watched Yahoo
go up to 20, 50, 100, 150, 300$ level. I am curious to know
what would have prompted him to sell Yahoo around that 400/500$
level. It is possible that his patience and guts may have glued
him to that Yahoo position, even when the YHOO stock reversed
its trend and price touched 10$ level back sometimes in 2002.
This is an extreme example and I have mentioned it to highlight
two things: Most of the investors get satisfied with small profits,
and a new type of Stop-loss- Progressive Stop-loss that
we will discuss later in this chapter.
What in
the case of CMGI or ARBA? It is very likely that individuals
who usually take small profits might have stayed in such losing
positions all the way to zero! My point is: Most individuals
play stock market like a D or F-grade student! When it comes
to booking profit, they get easily satisfied with a few points
of profit but when it is a loss situation loss, they are likely
to hold on and stick to the stock too long. Most investors are
more risk-averse (they hate the risk of profit going down) in
the profit zone and less risk-averse (they tend to take a lot
of risk in the hope that prices will go up someday) when in
a loss zone. This asymmetrical behavior is typical for most
investors. What is the end result? Small profits but big losses!!!!
This is the reason I advise most traders to use stop-loss when
they are trading stocks or Futures.
It is very
much feasible that (small) profits in ten positions can easily
be wiped out by two/three big losses! So even if a trader has
70 to 80% success rate in stock selection, we would hardly break
if he does not stop his losses! I think this is one of the main
reasons why our trading results in losses most, if not all,
of the time! I think this makes a solid case for every trader
to understand and learn to use a Stop-loss on every trading
position.
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:
Read
the Profit from Prices eBook online chapter by chapter.