How in­vestors should use stop-losses

Stop-losses are not only tools for traders to pro­tect their cap­i­tal. In­vestors should also de­sign their own stop-losses to help them de­cide when to exit po­si­tions.

Finweek English Edition - - MARKETPLACE INVEST DIY - By Si­mon Brown ed­i­to­rial@fin­week.co.za

in my col­umn A sim­ple rule for trad­ing: It’s all about con­trol­ling your losses, which was pub­lished in the 29 June edi­tion, I wrote about us­ing a stop-loss to pro­tect a trad­ing port­fo­lio and gen­er­at­ing prof­its by re­mov­ing all large losers, which gen­er­ated a flurry of reader com­ments. So, this week I’ll ex­pand on the con­cept.

The first ques­tion is: are you trad­ing or in­vest­ing? Sev­eral in­vestors seemed very alarmed by my com­ments and I agree with them as in­vest­ing is very dif­fer­ent from trad­ing. You would use stop-losses dif­fer­ently de­pend­ing on which process you are fol­low­ing.

Typ­i­cally, a trader mostly (if not ex­clu­sively) uses price to gen­er­ate en­tries, holds for a pe­riod shorter than three years and of­ten uses de­riv­a­tives. An in­vestor mostly uses fun­da­men­tals to de­ter­mine which stocks to buy us­ing price only for value, has a hold­ing pe­riod longer than three years and never uses de­riv­a­tives for the po­si­tion.

My col­umn from a few weeks ago was aimed squarely at traders, not in­vestors.

But as in­vestors we still need a stop-loss that will tell us when we were wrong and it’s time to exit. Here my trick is not to bother with price for an in­vest­ing stop-loss. Be­fore buy­ing any share for long-term in­vest­ing, I al­ways do my re­search, which I save for fu­ture ref­er­ence. I also record the top three rea­sons why I am buy­ing the stock. These three points are crit­i­cal as they act as my sto­ploss. Say I bought a com­pany and one of the three rea­sons was great oper­at­ing mar­gins, but then its oper­at­ing mar­gins start to shrink. Well, then I have a red flag and this would likely be a rea­son for me to exit.

This list of three rea­sons also serves to help me clar­ify my thought process and as­sists me in de­ter­min­ing what ex­actly at­tracts me to a stock. Then, if any of the three rea­sons stop be­ing true, I exit. This method is not per­fect and it saw me ex­it­ing SABMiller over a decade ago as one of my three rea­sons was “un­par­al­leled lo­cal dis­tri­bu­tion”. When the com­pany started go­ing off­shore, it weak­ened that point so I sold at a price of around R100, if mem­ory serves.

Us­ing stop-losses ef­fec­tively

For traders, the stop-loss process is eas­ier; you have a sin­gle line in the sand and if it’s breached you get out. That line may be price or a tech­ni­cal break, in­di­ca­tor or os­cil­la­tor. What­ever it is, when it is crossed, you sell.

Traders tend to make two mis­takes here. First, they want the ab­so­lutely per­fect stop-loss and that’ll never hap­pen. Gen­er­ally, stop-losses seem to hurt al­most as much as they help. You will be kicked out only to see the stock turn and run with­out you. This will hap­pen and we need to live with it be­cause there is no such thing as a per­fect stop-loss. But the crit­i­cal point is that they pro­tect our cap­i­tal and pre­vent large losses.

The sec­ond mis­take that most traders make is that they put their stop-loss level far too close to the en­try point, leav­ing no space for nat­u­ral volatil­ity. Af­ter 22 years of trad­ing I fell into that trap this year when I started trad­ing All Share In­dex (Alsi) fu­tures on an hourly chart. I was us­ing hourly av­er­age true range (ATR) for my stop-loss and on av­er­age it was about 250 to 300 points. But I was con­sis­tently be­ing stopped out. I changed it to daily ATR, keep­ing the en­try process the same. Af­ter that, the sys­tem started mak­ing a lot more profit as the trades had more room for volatil­ity.

With stocks, traders of­ten use 3% to 5% for a stop-loss. This is of­ten too re­stric­tive – stocks need space and ide­ally a stop-loss should be 8% to 10% be­low en­try. We then man­age risk by re­duc­ing po­si­tion size.

So, first un­der­stand whether you are trad­ing or in­vest­ing and use an ap­pro­pri­ate stop-loss method. Ex­pect some pain as you can­not make a profit in the mar­ket with­out oc­ca­sion­ally giv­ing back. Most im­por­tantly, start be­ing ruth­less with your stop-losses. ■

I also record the top three rea­sons why I am buy­ing the stock. These three points are crit­i­cal as they act as my stop-loss.

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