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Low Prices and Wide Stops

Oct 24, 2011 at 8:50 am in Risk Management by

To continue the theme of price gaps the I began in my previous article, I should point out that such price gaps are really only a problem if you employ non-guaranteed stop orders to manage your risk. You find yourself stopped-out at a massively disadvantageous price, and left out-of-position for any subsequent rebound. Arguably, it would be better to stop out at a guaranteed price or not to stop out at all.

This does not pose a problem for traditional “buy and hold” investors who do not employ stop orders and who simply hold on to falling and gapping-down stocks while hoping for the best. And it need not be a problem for spread bettors who take a similar approach.

Don’t worry, I’ve not gone mad, and my point is simply that when applying a prudent position size to a low priced stock, you can afford a very wide stop order… or none at all… and this means less chance of stopping out on a price gap.

Betting £10-per-point on a 10p stock risks only £100 in the absence of a stop order. Or, with a stop order at the 5p price level, you could go to £20-per-point for exactly the same risk — providing your stop order could ( as you would expect) be guaranteed at this very wide stop distance of 50%. On a 1000p stock you would surely need a protective stop order, and, on a modest £2-per-point bet, your stop order at 950p (to give the same £100 risk as before) could be too close to be guaranteed — so you’d be susceptible to gapping.

Let me put it another way:

If the spread betting company mandates a minimum £1-per-point stake and a minimum guaranteed stop distance of 15%, the smallest guaranteed risk you can take on a 1000p stock or index is £150. To risk less, you must lose the “guarantee” by applying a tighter stop and therefore also increase the probability of actually stopping out advantageously on a gap.

Think about how much of your risk you could “guarantee” to be gap-resistant by placing bigger bets (on a £££s-per-point basis, not in the absolute sense) with  wide stops or none at all on lower priced equities. And by having many of these in place, you’d also benefit from the additional protection and more chances for upside potential afforded by the increased diversification.

In the post-financial-crisis world there are many more low price equities than there once were. The only fly in the ointment, if there is one, is that the low-priced equities I’m thinking of — okay, let’s call them “penny shares” — may be priced low or a reason!

Well, you bet your money and you take your choice.

Tony Loton is a private trader, and author of the book “Position Trading” (Second Edition) published by LOTONtech.

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