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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 stop-loss. 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 thathey 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.
This article originally appeared in the 27 July edition of finweek. Buy and download the magazine here.
