More Questions about Stop Losses

Q.145: Where do you place the stop loss?

A: This is one of the most common questions and numerous articles have been written on stop-losses. I've even tried to address the issue of where to place a stop loss myself here. But to get a different perspective, Rakesh a full-time trader tries to address the issue of stop losses below -:

The way you manage your stop-losses will depend on your trading strategy. Setting stop-losses is a complex business, and a key skill that can only be acquired through practice. Traders frequently overlook it - to their cost. Choosing a suitable stop-loss level will depend on three factors: (i) the time horizon of the trading strategy; (ii) the instrument's natural volatility; and (iii) the general market conditions, including trading volumes and the newsflow surrounding the instrument in play.

The most popular strategy is to identify major support and resistance points and place a stop-loss just beyond these points. Which support and resistance levels you select will depend on your time frame. Less convincing ways to set stop-losses include fixed-price stop-losses at a set percentage away from the current price, or using an arbitrary stop-loss a set number of points away from a price that is calculated by estimating how much you are willing to lose.

Identifying support and resistance levels should be a fairly straightforward task with a decent charting package and reliable price data. The more times a price has come off a certain level, and the longer the time period involved, the more significant the level. Round numbers and landmark figures often prove significant, such as 7000. But placing a stop-loss at a round number is to be avoided, just as you wouldn't put a stop-loss exactly at a support or resistance level.

Remember, though: the only time you should ever move a stop-loss is to protect a profitable position. If you get your trade wrong, then throw the towel in, reflect on what happened and move onto your next trade.

Allow your personality to tell you how much of a loss you can take before you start making emotional decisions. So only take trades where the stop-losses will allow you to stay within your comfort zone.

Also, look at the daily range high-to-low on the instrument, and factor this into your stop-loss placement. Observe similar instruments or related markets to see if there are any clues as to where support and resistance points lie, and look for major chart patterns. Most importantly, though, try to define the general market conditions for the instrument you are trading. Identify if they are bullish, bearish or sideways, and place your stop-losses accordingly.

On a really bad day it's now crystal clear that we can't depend on Barclays Stockbrokers to enact stops at the set price. Here's the dialogue:-

'Why didn't you sell at my stop price rather than wait an hour into trading and sell at 20% below the stop price?'
'The price dropped overnight'
'No it didn't it was trading at the stop price from 8:00 until 8.15'
'We were busy and it was a very volatile share'
'No it wasn't. There were only 50 deals in it in the first hour'
'Customers who placed their stops first were dealt with first'
'My stop had been lodged 7 days previously'
'Well - the market maker took the share off automatic trading and we had to deal with it manually?'
'What - all 9 Market Makers took it off automatic simultaneously?'
'I don't know - but you should have put a limit on your stop price'
'But if I'd done that it wouldn't have been sold at all'
'Possibly - but a stop price only means that we'll sell it - it doesn't mean that we'll sell at the price you put on it'
'But that's the whole point of a stop order'
'Our stop order only guarantees to execute - it doesn't guarantee the price. Yes your share could have been sold at the price you set but by the time we dealt with it manually the price had fallen further'
'And are you going to recompense me for that?'
'No'.

Q.146: A lot of people stress stop losses - but if that was all there was to it surely more people would win?

A: Stop losses work as part of a structure. They are great as once setup they remove you from the equation.

Say gold is trading in a range between $715 and $739. As Warren Buffet correctly says 'no one rings a bell at the top' or indeed the bottom.

So let's say you put on an order...

If gold hits $720 BUY...

If that executes

1) Then an automatic stop loss of $715 is created (why?...because if Gold goes that low it's fallen out of its range and will decline to the next support level) .

2.) A limit profit sell order at $730 is created.

You could then go and leave it to its own devices, go for a walk, have a cup of tea, hump the girlfriend...etc.

------------------------------------

An alternative might be BHP Billiton hitting a record £1750.00, say I'm a cash investor and think the stock has overrun.

So I put in a sell order with a stop loss at £1775.00 (because maybe I'm wrong and maybe there won't be profit taking).

And a limit profit order of 1700.00 because I believe the stock will rally, and has support at this level.

Now I've locked in a profit, and if I'm right I'll be overall neutral on the sell-off, but in effect make a second gain when BHP eventually rallies back to £17.50.

Q.147: What's best using a guaranteed stop loss or ordinary?

Still getting to grips with spreadbetting, pretty annoyed at being bounced out of a Tate & Lyle long last week, my first £10 a point spread for £190 and today I would have been up £150. I used a guaranteed stop loss and I am right in saying that you can't alter it. I'm a little bit nervous of using an ordinary stop loss, how quickly do they get you out? What's best using a guaranteed stop loss or ordinary?

A: I don't often make use of guaranteed stop losses - though I fully understand the sense in doing so. Best thing is to chat with someone at the firm about what can and can't be done regarding adjustment of stops, and how close or far away they can be set, as rules differ between the various firms. Usually best to phone them outside market hours when call pressure is less hectic and they'll take time to chat. There is nothing to stop you having the same chat with the spread betting firms that you are not using, as some are better at explaining things. Just pretend you are considering opening accounts with each.

£10pp on a stock of that price sounds quite big for someone finding their feet, if you don't mind me saying so. Equates to a shareholding of around £6900.

Stake(£) x shareprice(p) = shareholding value(£)

One point - which you may know already; the stops can be set so they are triggered by the market price, or by the firms own quoted price. The latter will sometimes be a long way from where the market price currently is and might swing around more than the market price. Some firms ask whether you want the stop determined by market price or quote price. If you opt for market price, the stop will be triggered by movement in the market price, but will nevertheless be executed at whatever is their current quote price - so you need to keep an eye on both to fully understand what's going on.

P.S.: With spreadbetting there are several oddities that only become apparent when they happen. So it is worth getting a wide sample of bets of different kinds under your belt over several months before thinking it's safe to ramp up your stake sizes. I have been spread betting several years now, and I still sometimes get caught by technicalities (e.g. miscalculating the adjustment involved when certain corporate actions kick in).

Q.148: I have a question in relation to protecting portfolio profit...apart from the stop loss, and trailing stop loss strategy, are there any other methods for locking in profits without hurting the chance of further gains? For instance, buying puts on the XJO? Selling SPI futures? If you anticipate a market top, or is this faulty logic...should we just trade with the trend until it corrects us out by hitting our trailing stops...??

A: Hedging is a cost which is why institutions don't do it - traditionally over time you might expect to pay anywhere from 2% to 5% per quarter depending upon market volatility.

Read a bit of Mr Buffet's comments regarding the irrationality of Mr Market...etc

The concept of Mr. Market goes something like this: imagine you are partners in a private business with a man named Mr. Market. Each day, he comes to your office or home and offers to buy your interest in the company or sell you his [the choice is yours]. The catch is, Mr. Market is an emotional wreck. At times, he suffers from excessive highs and at others, suicidal lows. When he is on one of his manic highs, his offering price for the business is high as well, because everything in his world at the time is cheery. His outlook for the company is wonderful, so he is only willing to sell you his stake in the company at a premium. At other times, his mood goes south and all he sees is a dismal future for the company. In fact, he is so concerned, he is willing to sell you his part of the company for far less than it is worth. All the while, the underlying value of the company may not have changed - just Mr. Market's mood.

The best part of this entire arrangement: you are free to ignore him if you don't like his price. The next day, he'll show up at your door with a new one. For your interest, the more manic-depressive he is, the more opportunity you will have to take advantage of him [don't worry, he doesn't have feelings or mind being taken advantage of.] As long as you have a strong conviction of what the company is really worth, you will be able to look at Mr. Market's offers and reject or accept them... the choice is yours.

Q.149: In setting trailing stops for downside protection do you have any advice of a percentage and/or methodology that works well for them in regard to getting stopped out in a market blip? I am using 5% as a trigger.

A: Percentages don't work well, always too little or too much. Knowing support/resistance levels doesn't work well, again always too little or too much. For my taste, trailing stops are a strategy to let you more-or-less maximize profit, not a protection mechanism. When I start worrying about minimizing loss, I blow out, now. There is effectively no protection mechanism that won't shoot off a toe now and then. A good approach I've found when day trading is to enter the position, watch it like a hawk until it goes profitable, then set a trailing stop behind it and keep moving it until you exit the position. If you know the issue well enough, you can improve on that... somewhat.

Once in a while you will get stopped out and take an unnecessary loss, but if you know where to set your stop, then this won't happen too often. A sell stop is not an offer to take a loss, but an offer to protect you from greater loss. It's the point where you say 'I was wrong about the trade - take me out of it.' If you're often getting stopped out of good trades, they you're setting your stop too close.

For me it also depends on whether the position I've taken is in the green or red. Also, the size of the position and the volitility. My sentiment factor, somewhat affects this as does the intent of the trade (daytrade, medium or long term hold). I am also of the philosopy of getting out and buying back in.

But even if you have a stop set and you are green and everything is looking good,some ****ing raghead may drive a plane into something and shut the markets down until you are screwed beyond belief.

Q.150: I went to move one of my GSLO's online after the market had closed, only to get a message on the screen that I could not move my stop closer to the market price unless the market was trading. I'm just wondering why?

A: Some spread trading firms will only allow stops to be moved when the market is trading, the same restriction applies to some physical markets as well.

Q.151: I'm confused - how are stops not a form of protection?

A: In 1987 (aka Black Monday) lots of people thought that their 'stop loss' order would protect them. Instead they just contributed to increasing the avalanche of sell orders, driving the market even lower. Once a stop was triggered it became a 'sell at any price' and queued behind all the other existing sell orders. By the time many such orders got to be executed, the price was much lower then the mere few percent decline specified as the trigger point.

If, you were using a guaranteed stop and we experienced another event like the 1987 stock market crash, you would be stopped out at the level you specified. You would not incur the 'extra fall' (which is what is referred to as 'slippage'). With non-guaranteed stops, your stop level is not guaranteed. Therefore it could be subject to slippage and which is dependent on market conditions. Unless guaranteed, the 'stop loss' will not be of help in these situations.

Q.152: What are the limitations of stop losses?

A: So far as regards a stop loss or some such, I say as follows:

When I enter a position I never have in mind a price below (if long) or above (if short) which I would seek to close. The reason for this is quite simple. If I were to open a position and simulataneously consider the magnitude of loss I am prepared to take, it would suggest, to me at least, and that I was not certain of my stance and hence should not undertake the trade. You only open a position if you are certain that it shall go your way, otherwise there is no point in doing it.

It has been mentioned before that the 'the market can stay irrational longer than the investor can stay solvent'. Hence, inevitably occasions may arise (even for the gracious fellow) when it appears that the price action is not as anticipated. Providing one has sufficient margin, this ought not to be a concern. However, if the facts have fundamentally altered since the position was taken, then one ought to consider if a change of stance is appropriate.

Take the example of SPD - I shorted at around 100p and then subsequently in the nineties and even lower. Initially the price went my way, with the stock going down to 85p. But I did not close since I took the view (and still do) that the company cannot make good the EBITDA forecast, notwithstanding the fact that it has stated it will. Hence the price (supported by a small free float, share buyback and ill judged comments by the Chairman) has risen considerably. Due to the factors above, it might continue its rise. But the reason I shorted has not changed. SPD is in a challenging environment, with poor sentiment, eroding margins and a complete lack of visibility going forward. Readers may suggest that it is foolish for me not to have closed at say, 100p, and gone short now. Easy with the benefit of hindsight, but the truth of the matter is I never anticipated the factors that have contributed to the rise. Such price action is immensely difficult to incorporate into any analysis, and ordinarily I tend not to focus on it.

Whilst the idea of having a figure in mind as regards losses is a foolish one, often circumstances dictate otherwise. If tomorrow, all the stocks of which I am short were to double, I would be forced to accept the losses and close some trades. Thus, I never overexpose myself and have sufficient funds at the ready should a stock even incur a 50% loss or more. The other reason I do not set stop losses is because they encourage momentum trading. One can easily focus on a few per cent either side and then try to close and reopen thus scalping a few pence. This is habit forming and can lead to one missing out on having a core holding because rather than scalping a few points you do not wish to buy or short again because had you not tried to trade it you would be a few pence in the money. Such momentum trading is easy to get into, and for those who trade for the longer term is a trait that needs to be dispelled. Recently, I have been guilty of the same, but only because there has been considerable volatility. I have on several occasions traded the banks since the swings have been huge. I soon noted that I was keen to do the same with other stocks, but then reminded myself the errors that such an approach can generate, and thus stopped it immediately.

Virtually most traders swear by a stop loss. The thesis is quite simple (assuming linear weighted trades) - if you maximize your loss per trade to say 5%, you can afford 10 losing trades and still simply have to call one right by more than 50% to be in profit overall. On the other hand they will tell you, without stops just one losing trade of 50% would require 10 winning trades of at least 5% to break even. Thus, the balance of probabilities would appear to be in staggering favour of such an approach.
Not quite. If you consider that most traders simply adjust their stops as they go long i.e. if the stock moves higher for a long position, they simply raise the stop by the initial percentage towards the new price. The problem thus, is that since markets and stocks do not move in straight lines one would rarely if ever catch the full or significant part of the move since on any pullback or rise (depending on whether you are short or long the stop would have closed the trade. This is especially true in the current volatile markets. Hence the thesis of 'run your winners and cut your losers' is not really a reality for those that apply tight stops.

How much I am prepared to lose on a single trade is not something to which I can give an answer since one does not exist. It really depends on what it is. If I am having a speculative punt on a AIM tiddler, I would be prepared to write off a significant loss since it would only be a fraction of my portfolio. If on the other hand, I was short a FTSE 100 company and the stock rose some 30% over a period of a year I would have to seriously consider reducing my exposure unless it was obvious it would retrace (in which case I would consider adding to the short).

It all depends on why you opened the position in the first place. That, ongoing newsflow and market forces dictate when you exit. But I always seek to exit based on facts and value, rather than price if it can be helped. So I must emphasize that watching your margin requirements and ensuring reserve capital are key.

Here we discuss the benefits and limitations of using stop losses in more detail. We also discuss where to place the stop loss level here.

Q.152.1: 'Problem is that sometimes I end up with stocks that go in the 'wrong direction' for a long time as I don't like exiting with a loss...�

A: Oh dear. Yes - it does take a while to accept that losses are for taking not for nursing. But it is vital to get to the stage where zapping losses becomes a badge of honour (being the right thing to do) - not an admission of defeat. And the smaller they are the better - which usually means taking them early. Most beginners find it difficult to get there. Having invested so much belief and care into choosing a position in the first place, it don't feel right to abandon it almost immediately. It's as if doing so casts doubt on ones judgment. It takes all of us a long while to come to terms with the need to be clinical.

It doesn't even matter if losses outnumber wins - as long as they don't outweigh them.

Many traders happily operate with losses routinely outnumbering wins. Sixty losses to every forty wins is a perfectly OK ratio. If losses are taken early it is quite likely there will be lots of them showing on the ledger - but as long as they are tiny, that's fine. It doesn't even matter if the decision to take the loss subsequently looks to have been unnecessary - because being such tiny issues, they can be shrugged off ;o) .

One of the biggest advantages of spreadbetting (a truly huge advantage in my view, and overlooked by many), is that there is no cost penalty in exiting a position in stages. This removes that dreaded stress-laden moment of deciding to give a position the chop - when so many traders who set an exit level find themselves 'frozen in the headlights' and reluctant to push the sell button... and end up dithering - only to see the price get worse - and then falling into �Oh well it's too late to get out now, I might as well grit my teeth and hang on in there� mode.

Exiting a conventional holding in stages is costly - paying brokers commission on every partial trade. But with spreadbets I will quite often trim a position and trim again - and all the way out if the price continues misbehaving. There is thus no single major exit decision involved. Or you can set a phased stoploss framework - in which you might exit a third of the position on a 5% fall, another third when down 10%, and only dump the remaining third when down say 15% or 20% whatever - so you feel you have given the stock every chance before killing it.

My accounting period is the tax year. I have made more losing trades than winning trades (first time that has happened) but my win : loss ratio ratio is over 2:1. Job done. By the way, if you don't have a clue what your personal ratios are then you are not managing your money properly. You can lie to your friends, family and on board rooms but don't delude yourself. If your win : loss ratio is negative or close to 1:1 then, in my very humble opinion you are doing something wrong

Q.152.2: I like your comments about trimming your positions. One thing I ask is how do you exit in thirds on a spreadbet?

What you say about trimming down would also work on trimming up to reduce the impact of a trade in positive territory being wiped out by a reversal. It seems an inherently wise thing to do.

As you say the trade costs is an issue for holding actual securities, especially if your trades aren't big in the first place. All this is very a la Mark Douglas, Trading in the Zone. One thing I ask is how do you exit in thirds on a spreadbet? Do you mean reduce the Pounds per point?

A: On some accounts you can do that by adjusting the existing bet - on others you do so by merely placing a new bet in the opposite direction (placing a down bet stake of say �3pp and thereby reducing the existing �10pp up bet to a �7pp up bet) .

One thing I like about the IG platform is that bets are displayed in a way that it is possible to exit multipart bets in any chosen order. If I have opened say three �10pp up bets on the same stock, at different entry prices, and the middle one of those three is the one I want to close, I can do so. With Cantor I can bring up a detail of the three bets but can only exit them �earliest first� which doesn't always tally with what I would prefer doing.

And I agree with you regarding phased exits on winning positions too. I do that all the time. On DCG this morning for example I opened a down bet and subsequently closed 80% of it, banking the bulk of the gain but allowing a small stake to continue awhile - knowing that if it were to spin back against me it could only do so at a less damaging rate. At 11:20am I closed the remaining 20%.

(my DCG bet was actually a little more complex than that. But banking a big part of a gain and allowing a small bet to run on for a few more points is something I do on many trades).

...Continues here - Tipsters, Seminars, Oil Stocks & More (page 19)

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