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Should one use stop losses?

Posted By Robert On Friday, January 3rd, 2014 With 0 Comments

The idea of stop losses/trailing stops etc is to get you out at a logical place in a manner which can be done consistently over 100’s/1000’s of trades…now in trading like life nothing is perfect. There will be times where stops are taken out and the share then rebounds, and goes straight up again, and you think shit…there are other times it then crashes after and you think wow I’m a hero..the key thing imo to remember is that say you do 500 trades a year or whatever. Each trade is just one cog to the end destination. i.e. instead of just thinking 1 trade at a time, you got to think about the overall 500…that’s where having a trading plan comes in, and a written one at that…

A big part of my trading ethos is to avoid losses. That is why I use automatic stop losses.

A stop loss is a predefined selling point. A stop loss can be either automatic or notional. Automatic means that it is entered into your online brokerage account and the sale will happen if the price goes down to that level. Notional means that you have a selling price in your head and you sell when the price reaches that point.

I prefer to use automatic stop losses for two reasons:-

  1. I can’t guarantee that I will be available to react – I lead a busy life and may not even be near a computer for a week
  2. Psychologically it is sometimes tough to sell – you believe that the market will reverse and go the other way. Better to remove the emotion from the decision to sell.

I use trailing stop-losses to ensure that the level that I sell at moves upwards as the moving average increases. This locks in more of the profit. I update the trailing stoploss every weekend. It is a habit worth getting into!

I would suggest to work out what’s the best stop loss/trailing stop/profit management strategy for you, you have to first work out the type of trader/investor you are, and what you are wanting from the markets. If you are a Zulu investor, you will have a different stop etc than if you were a swing trader etc…

But in general an investor/trader seeking a reasonable income and preservation of capital should use stop losses. How large of a stop loss? I feel that could vary from trader to trade, but I do feel that some stop loss amount would appropriate.

While setting a stop as a percentage is fine in principle it’s not necessarily one size fits all. Have a look at the ATR (Average Trading Range) for a particular stock and then set your stop a multiple of this below depending on your comfort zone i.e. 2x, 3x, 5x ATR.  Alternatively, look at the chart and asses previous lows that were bought up as potential support and set your stops below this. Further, tighten stops when markets get the jitters and relax them when you’re comfortable.

  1. Have your own system.
  2. Use stop losses set against market turning points not your own cost.
  3. Sit on your hands and just watch 38% of the time.
  4. (Even if you are David Linton don’t boast about your hols on Grand Cayman).

Diversification is another aspect of Prudent Man thinking. There are very little rules or guidelines concerning diversification. I use an 8% maximum as a guideline. Some may feel this is too conservative, while others may feel it is too large.

In a nutshell, if you’re not prepared to take the loss (because you’re convinced the trade will become profitable eventually), you have three options available to you:
1. Have no stop loss at all of any kind.
2. Have a very wide ’emergency stop’, which you don’t ever expect to get hit but, if it is, will prevent you from blowing your account.
3. Some sort of hedging strategy, so that you’re not spooked by the short term gyrations of the market before it eventually moves in the direction you expect it to go.
There may be other options, but those are the main ones that spring to mind. Thinking about it, a 4th option is to wait until there’s clear evidence that price has finished chopping about and is making its move – and only then enter the trade.

The purpose of this is to get you think about some of these issues in your own trading. Take a look at your portfolio, balance, risk and ask yourself if your strategy is prudent. You don’t want to look back and wonder why you did not have better diversification, use stops and manage risk in a more prudent manner.

Here’s a comment I received from a trader who requested to remain anonymous.  He comments on what basis he uses stops -:

I sometimes use relative strength of the 26 week sma, if it falls below the 52nd percentile it goes, less often I also use the PSR, which has to be higher than 8th percentile and lower than 67th. I’m less worried about stops in this portfolio, it’s more worry about when to take some profits.

Other buys I use 2x ATR or 10% or a trailing stop. But I found trailing stops don’t work because the market is so jittery you find the stop just keeps creeping closer and closer as the price works it way up or sideways.   As to resetting stops once you’re in profit, I think setting it to the high of the day would get you taken out the next day on a lot of shares. This is an area I have problems with. I don’t set hard stops unless I’m spread betting. I have quite often lost 10% or more on the profit of a share and stayed in and then it’s gone back up. Some people would sell and then buy back later. In this market that’s probably the right thing to do. A strict stop rule would help.

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