Why would anyone like any sort of losses?

Why would anyone like any sort of losses?

Call me old-fashioned, but I think the objective of investment is to profit, not lose.

When I write a big cheque, I do it for a reason. I expect to profit.

Barring a change in fundamentals, a price drop suggests further buying. Selling is illogical. It makes a mockery of your investment decision process.

Stop loss orders is a service offered by brokers. I rest my case.

This was the question I received a few weeks ago from Nicholas. Since I thought this might be of interest to our readers I'm publishing the answer here:

Wrong !! Two classic mistakes:-

  1. Following a loser down - you are just increasing your loss or potential loss.
  2. Not insuring that you minimise losses.

Stop/Loss orders do two things:-

They limit your losses and they can (if used as trailing stops) lock in your profits.

The decision on whether using stop losses or not depends to a certain extent on your leverage. An ungeared investor could probably afford to ride out a temporary soft patch. A highly geared investor may not be able to do so.

If your spread trade is leveraged at 40:1, a bad week can cost $20,000 on that trade alone. If it's marked to market and subject to margin calls, it may not take many bad weeks before bumping up against hard cashflow constraints. I prefer a greater degree of certainty in my cashflow planning.

Stop loss mechanisms can be a good way to avoid margin calls or catastrophic losses, so they can be an effective risk management tool.

Let's review the top 10 classic trading mistakes. They are -

  1. Trading against a trend - buying when the stock is dropping.
  2. Not Adhering to a stop/loss position - i.e. if it goes down - dump it before you lose even more.
  3. Taking greater risks to recover losses - increasing a falling position - the old world war one pilots had a rule about following a target down once they had taken the kill - stock traders should adopt this principle.
  4. Letting a profit turn into a loss - i.e. not setting a trailing stop to lock in profit.
  5. Overtrading - breaking discipline.
  6. Lack of diversification - they are not going to win all the time.
  7. Trying to solve financial woes by trading - just head for the casino.
  8. Not having defined objectives ( and a defined strategy ) to ensure discipline can be measured.
  9. Lack of discipline - generally you need to define a set of objectives and a strategy and stick to them. If they are wrong find out why and redefine them. How many traders out there have a defined strategy??
  10. Knowing it all - see discipline !!

As far as stop losses go many people use either an absolute dollar figure or a percentage. I prefer a stop/loss calculated from the ATR (Average True Range) - it takes into account variations in the current volatility of the price and re-adjusts every day (at least). Also TRs tend to contract when a stock pice is moving up or down. I have seen ATRs which give 3% and I have seen others that give 10+% - the trick is to make sure that your stop/loss doen't fire during flat trading because of volatility.

Note: The average true range is a moving average of a stock's range for the day. A stock's range for the day is the high of the day minus the low of the day. Average True Range (ATR) is an indicator that measures a security's volatility. As such, the indicator does not provide an indication of price direction or duration, simply the degree of price movement or volatility. High ATR values indicate high volatility and may be an indication of panic selling or panic buying. Low ATR readings indicate sideways movement by the stock.

This is where the art and the science meet - setting your stop/loss so that it doesn't fire in the normal trading range of a stock. For this reason I, personally, don't like the fixed percentage or fixed value stop loss approach. I much prefer a dynamic stop/loss calculated from the ATR and given a sufficient factor to avoid early triggering. Generally the ATR contracts during both a rise or a fall in the stock price and should be adjusted regularly.

Maybe I'm using the term 'stop-loss' in too loose a sense. Perhaps hedging would be a better description. My leveraged positions are almost always hedged ex-ante. I am usually prepared to give up a little upside in exchange for avoiding the catastrophic loss of my money. I don't think this makes me foolish, I think it makes me a survivor who is prepared to walk away from losing trades in order to be around to make a killing on winning ones.

>> Page 10 - Where to place the Stop Loss Level

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