Stop-loss: Add science to the art of using stoploss
Stop-loss is a widely used term in investment circles. As the name says, it is a price level at which you should stop or limit your loss in a position. Investing or trading is a sort of gambling. When you gamble or speculate, you don't know what the outcome would be. You hope for the outcome to be in your favor but it could very well go against you. Same thing with investing or trading. When you buy a stock, you think, and to a great extent you believe or hope, that the stock price is destined to go up, but it could go up or down irrespective of your wishful thinking. So what do you do if price goes down? You have two alternatives: (i) Hold on to it believing, and hoping, that it would ultimately go up. (ii) Or you blame the unexpected mess on your wrong selection or bad timing and get out of it.
What is a stop-loss?
I hope
you understand what a stop loss is. If you buy a stock ABC say at 25$, your stop loss would be somewhat lower
than 25$. It can be 24, 23, 20 or even 15$. Let us assume you kept it
at 20$. This means if the price of ABC, after you bought at 25$, goes
below 20$, you will sell it and book the loss of 5$ per share. Is this
clear? This might be little confusing for novice investors. In long
position, your stoploss level is lower than your purchase price.
Likewise if you short (what is this term? It means
sell first even if you don't own in a hope to buy it later at a lower
price) a stock ABC at 25$, you may keep a stop loss at any
price above than 25$. Say if you kept it at 30$, this means if the price
moves up contrary to your initial expectations of it going down,and
hits 30$, you would call quit and square up your position. Thus, in
a short sell, the stoploss prices is higher than your sell price.
Costs and benefits of using stop-loss mechanism
Use of stop-loss has its merits, and problems too. You may have bought a stock like, say CMGI or ARBA around 150 or so during 1999-2000 boom thinking that it was a great company (believe me most of the investors thought so at that time). And if you held onto that position during its down trend (hoping that it would ultimately reach 200), you would have to face the hard reality and see the stock price at 1 to 2 dollars! In such situation, you would sure wish you had kept some stoploss and limited loss to 5 or 10$ per share, if not 20 or 40!
On the other side you might have bought Yahoo at split adjusted 10$ in October 1997 and kept a stoploss at 9$. Let us assume the price went below 9$ triggering your stoploss and you were out of that 100 share yahoo position at 100$ loss. Then as time passed, you may have regretfully watched Yahoo stock price touching almost 500 dollars in January 2000. Your 1000 $ investment could have have been worth 50,000$ had you not kept that stupid stop-loss! So the question is: Should you use stoploss or not? Answer is it depends. If you are an investor purely with long-term perspective and with a diversified portfolio, maybe you shouldn't.
Should you use stop-loss?
As we all say, there is no free lunch in financial markets. So use of stop loss has its benefits and problems. In few paragraph's below, I would try to show you how to get maximum out of this stoploss mystery and use it in your favor. Let us go back to above two scenarios.
If you had bought Yahoo at 10 dollars and think you had not kept a stoploss, would you hold on to it until it touched 500 or you would be out before it even doubled or tripled? Be frank to yourself. I think most of the investors including myself would be pretty satisfied having doubled or tripled our investment over a short period. Let us assume you are a real patient investor and had guts to watch Yahoo go up to 20, 50, 100, 150, 300...I am curious to know what would have prompted you to sell Yahoo around that 400/500 level. It is possible that your patience and guts may have glued you to that Yahoo position as of today also when stock price is around 10$. This is just an extreme scenario and I have mentioned it to highlight a new type of stoploss- progressive stoploss.
The argument against use of stop-loss may not be as rosy in practical life as it appeared in above case. What in the case of CMGI or ARBA? We can easily find handful of people who are still in those stocks or who took significant losses in those stocks. My whole point is: We play stock market like a D or F grade businessman. When it comes to booking profit, we are satisfied with a few points of margin but when we have a loss, we continue to love and stick to the stock till our, or that company's, bankruptcy. Most investors are more risk averse (we hate risk of profit going down) in profit zone and less risk averse (we tend to take a lot risk in a hope that prices will go up) in our loss zone. This asymmetrical behavior is typical for most investors.
It is likely that our (small) profits in 10 positions can easily be wiped out by 2/3 big losses. So even if we have 70 to 80% success rate in stocks selection, we would hardly break even! I think this is one of the main reasons why portfolios of most of us are in losses most, if not all, of the time. I think this makes a solid case for every one to know and learn how to use stop-loss on most of our purchases or short sells.
How to effectively use stop-loss?
We all love to take profit but if things go contrary to our expectations, we should keep stop loss to limit our loss. Question is how much loss is enough? There is no clear answer to this question. If we don't want to lose much, we would keep stoploss close to our trade price. It will result in lower losses but would increase the probability of stoploss being triggered. If we don't want stoploss to be easily triggered, we should keep more distance between our trade price and stoploss. This will result in higher loss if the price moves against our position. So how much is enough? It is our choice based on our risk tolerance, our trading system and nature of stock itself.
So
how much is enough?
Look at the stock price, its volatility and return expectation to
determine safe distance (I don't find a better name). The range
is subjective but for an average investor it could be 5% to 25%. For
a 5$ stock, with high volatility and expectations for 100% return,
safe distance could be 25%. This mean if we buy at 5$, let our stoploss
be at 3.75$. In other extreme, for a 120$ stock with average volatility
and a target return of 30%, stoploss can be placed even at 3%. Such
stoploss will protect us from big unexpected losses so they are often
referred to as Protective Stoploss.
What
should be a base/price level to calculate our stoploss?
Assume we decide that 5% is the ideal stoploss or safe distance
percentage. Now another question is what level we should use to calculate
our stoploss. If we buy stock at 50$, most obvious choice is to use
50$ level and go for a safe distance of 5%. This will, i.e. 47.5$.
This is the most obvious answer.
However John Magee in his classic book on Technical Analysis of Market (a must-read for chart reading investors), suggests to use the minor tops and minor bottoms as the base points. It makes a lot of sense. Our purchase price has no meaning in the universe of constantly fluctuating prices but minor bottom (top) is a somewhat significant price level. It is the price where short term demand(supply) of stock is more than its supply (demand), at least for the time being. Minor bottom means buyers's strenght outnumbered selling pressure and vice versa for a minor top.
How
to decide a minor bottom? It is tricky and subjective. The world
of investors and analysts does not agree on one definition as they
never for most other investment related matters. (This disagreement
is the beauty that keeps, and has kept markets functioning over past
many years). Here also, I love John Magee's definition. Let me try
to explain a minor bottom:
(1) Prices are going down for some time (how much is some time?
It could be 2, 3 or many days. Use your intuition to figure it out
yourself)
(2) Say they make a low of 45 dollars on day X. The high on that day
was 48 dollars.
(3) Let us call this high price (48 in this case) on the low price
day(X) as a key price. As soon as we have 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 our case).
Same thing can be applied in reverse for calculating a minor top. Read this again and again until you comfortably understand it. If you don't understand, email me your confusion.
So for best results, use the minor top or bottom as your basis to calculate your stoploss. It will protect you better than your trade price.
What
is progressive stoploss?
Hold your breathe. Stoploss can also be used in our advantage
when we are right about our outlook on a stock's behavior. A protective
stoploss can be changed in our favor as the stock moves in direction
we wanted it to move. This makes it a progressive stoploss. (Stoploss word becomes deceptive in this context It is used to protect
your profits as much as possible).
Let us continue our example above. After a minor bottom at 45 was confirmed, we bought the stock at 50$. Our stoploss is at 45$ minus safe distance of 5% which is 42.75$. This is our initial protective stoploss.
Assume that stock price goes up as we expected and touches 55 and then slides back. It comes back to as low as 50$. The day it touches 50$, the high was 52$. Now again price seems going up and we have three consecutive days on which stock trades above 52$. This will confirm higher minor bottom at 50$! Now we'll raise our stoploss to 47.5$ (50 minus 5%).
The stock resumes it up-trend makes a higher top at 65$, then slides back to 58$ and it passes our test of a minor bottom at that level. So we raise our stoploss to 55$ (58 minus 5%). We are in profit now and our profit is sure! We want to ride as much as we can. Assume the upward trend continues as we had expected. A top is formed say at 85$ and then a minor bottom is confirmed on our three consecutive days test at 78$. So our stoploss is now at 74$ (78 minus 5%).
Now say after last top and bottom being confirmed at 85 and 78 respectively, the stock fails to go higher than 85. This shows weakness. Now if it starts going down and goes below 78$, we can feel the weakness in the stock. Still our 5% safety margin will mostly save us if it is forming a mid-trend pattern like flag or pennant. If after going as low as 75$, assume that the stock resumes its upward trend breaking level of 85$. We are still in the game! However if it does not go higher and instead goes below 74$ (our current stoploss), we would be out with a profit of 24$ (74 -50)!
One real example as it is happening:
I guess
we all know Broadcom- a one way superstar. Its up-trends are as crazy
as its downtrends. Recently I found a value in it and was closing
following it. It kept drifting from 40$ down to less than 20$ but
did not confirm any minor bottom on the way on 3-consecutive-days
test. Ultimately it touched 18.40 and then after on 3rd, 4th and 5th
day it passed our 3 day consecutive rule! It formed a minor bottom
as marked on the chart. It was a buy signal for the first time and
we could have bought around 25$. Our protective stoploss should be
kept at 16.5$ (18.4 minus 10%). So loss potential of 8.5$/share.
The next bottom Bottom2 was confirmed at 27.5$ which would bring our
progressive stoploss to 25$ (27.5 - 10$). Then it made another higher
minor bottom Bottom3 around 33 bringing our stoploss to 30$. Currently
it is 45$. It is your choice. We can book profit of 20$ (our poor
nature...we can't stand too much profit!!!) today or like a ruthless
trader, we can keep holding with a 30$ stoploss and keep raising our
stoploss progressively higher as new higher bottoms are confirmed.
Hey, it is Broadcom! It can touch even 100$!!!
Do you
think this article was helpful? Please email me at 
Thanks. Enjoy investing.
Link to Best Market Articles
