God I so hate this subject - I have no idea why I am writing this. I have been meaning to Blog away on this for weeks but every time I knuckle down to start it, my crafty primitive brain always seems to distract me onto some other subject. I definitely have a psychological problem with regard to Stoplosses.
I think it is because deep down and by nature I am very much an Investor - not a Trader. This means I undertake a lot of Analytical effort on companies I invest in and I struggle with the idea that just because the Share Price of a brilliant company has dropped 10%, then I should sell it. It just makes no sense - my brilliant company has just got 10% cheaper !! If anything, I should be filling my boots.
What is a Stoploss?
The simple idea is that when you buy a stock, you set a level below the entry Price where you will sell it NO MATTER WHAT HAPPENS. I have highlighted these words because they are extremely important - you cannot set a Stoploss and then just arbitrarily choose to ignore it - if you do so, then you are letting your psychological cognitive biases overrule a hard and fast rational rule that is supposed to protect you from your own stupidity.
OK, an example. Let’s say you buy a Stock at 100p. You decide that you will use a 15% Stoploss, so you set the Stoploss level at 85p. If the share price moves down to 85p, you sell the shares and you take the loss. It really is that simple.
As ever, there are a million nuances. I outline some here:
‘Hard Coded’ or manual?
You can either sell the shares yourself by going into your Sharedealing Account and selling them or most Brokers provide the capability to set a Stoploss level within the online platform where the Shares will automatically be sold when the price hits the Stoploss Level. The problem with an Automatic method is that an Intraday Spike down in the Share Price will trigger your Stoploss and close out your position (sell your shares) - just before the price swings round and moves up again.
Readers who understand how Dragonfly and Hammer type Candlesticks work, will realise that these big Intraday Down Spikes are often a Capitulation (the final Bears sell out in utter frustration and panic) pre-cursor to the shares turning back up after a short term downtrend. So, Stoplosses have an uncanny habit of getting you out of a Position just as it is about to turn back up - this is one of the problems I found when actively trying to use Stoplosses.
Another issue with Automatic Stoplosses is that they can ‘Slip’. Easiest to use the Example - say you buy at 100p and set an Automatic Stoploss at 85p. Let‘s then imagine there is a panic in the market (especially likely on small, illiquid stocks) and the Price rattles down through your 85p Stoploss level and by the time the Broker’s automated system sells your shares, you actually only get 82p. So your 15% stoploss has become 18% - you have been a victim of ‘Slippage’. Be warned.
One way around Slippage on your Stoplosses is to use Automatic Guaranteed Stoplosses - these are available on many Platforms but they incur an extra Charge at the time of Opening the Trade. If the Share Price moves against you very fast, it does not matter because the Stoploss Level is fixed - Guaranteed. However, read the Terms & Conditions of your Broker as there may be ‘Get Out’ Clauses.
I think ‘Manual’ Stoplosses with a Sell action determined after Market Hours in the cold light of evening or over the weekend is the best way to operate them. That way you are working on ‘End of Day’ prices and you have the advantage of Candle patterns and other technical factors to help your decision - but of course you can be influenced by your CavePerson brain (how Politically Correct is that?). You make the Sell decision overnight and Execute the Sell the following morning. This is something I will return to over and over, but if you make these kind of important decisions during the trading day, your emotions will be affected by that day’s activity.
This is another logically brilliant and simple idea. The way it works is you buy your Share and then as the Share Price moves up (you have bagged a cracker here you Superstar), you move the Stoploss Level up behind it.
Example time - say you buy at 100p with a Stoploss at 85p. As the share moves up to 110p, you move the Stoploss up the same amount - i.e. to 95p. In this case, you will not protect your profit but it means the Maximum Loss you can take is just 5% - so your Risk on the trade has reduced from your Opening Risk of 15%.
Then let’s imagine the Price moves up to 120p. Now your Stoploss moves up to 105p - so at this point, you will be guaranteed a profit of 5%, whatever happens. Beautiful is it not?
You basically carry on in this fashion, moving the Stoploss Level up behind the Share Price.
Some Dealing Platforms have a Function where you can have Automatic Trailing Stoplosses - these are superb but make sure you understand the mechanism by which they work - they do vary across Platforms. One issue I have found is that you set them at an Account Level - so all Positions are dealt with using the same ‘rule’ - this is a bit silly as I would argue that each Stock needs it’s own rule and parameters.
A Better Way to set your Stoploss Levels
Using a Percentage is a simple and logical method - but it may not be optimal. A better way might be to use a Stoploss Percentage IN COMBINATION WITH the use of Support Levels on the Price Chart.
Let’s build on the Example. Let’s say you bought the stock at 100p as usual and you want roughly a 15% Stoploss which would be at 85p. However, when you look at the Price Chart, you see there is strong Support around 90p - in other words, the Price often dips down to 90p but then turns up again - so 90p is a level where Bulls come in and get the upper hand over the Bears.
In this case, you set your Stoploss Level just below the Support Level of 90p - maybe you set it at 88p. I hope this makes sense.
The Market ‘Hunts’ your Stoplosses
This might come as a shock but I have witnessed and suffered from it many times. Again, despite the apparent Beauty and Logical Simplicity of a Stoploss, in practice there are many challenges.
What happens here is that you set your Stoploss at a sensible level below your Buy Price and you think you have allowed for Support Levels and you have a great Trade in the making. Where it goes wrong is that the Market ‘Hunts’ down your Stoploss Level - it probes away going lower and lower until it finds your Stoploss Level. The reason for this is that where you set your Stoploss is similar to hundreds if not thousands of other traders.
The Support Level and your Stoploss Level create a Self-Fulfilling Prophecy - all traders look at the same charts as you. Anyone buying your share at 100p or in that region will probably set their Stoploss around 88p or so - the Market knows this. Other aggressive Traders actually sniff out your stops so they can buy your Shares cheap just before the price shoots up higher.
Yep, the Stockmarket is a dirty game.
If you are Shorting a Stock (i.e. Selling a Stock where you do not hold any - usually via a Spreadbet), then Stoplosses work the opposite way.
Let’s say you Sell this turkey of a Company at 100p. This time you would set your 15% Stoploss at 115p - so your position closes out if the price rises to 115p and you take the hit. It’s really just the mirror image of everything I have written above.
Why do I detest Stoplosses so much?
I have clearly indicated in this Blog that I struggle with Stoplosses.
I suspect a huge amount of this is Psychological - I just cannot bring myself to take the pain. This might well be a failing in my Investing Prowess - many will argue it is. However, I have battled with this over and over and I have tried using Stoplosses on all my Buys many times - it is never successful.
What tends to happen is I just get a string of Buys where I get Stopped Out and I take a 15% loss or so - over and over again. Apart from crystallising these losses, it means that all the Research and Analysis I have done is wasted - and invariably the stock turns around and goes up anyway - so I was right but my timing was slightly off. This problem is magnified during moments of General Market Panic and Sell-offs - you get stopped out everywhere.
In a sense, when you use a Stoploss, you are swapping one type of Risk for others. What I mean is this - by using the Stoploss, you are swapping the risk of your share falling further for the New Risk that you will buy another stock that is a duffer - “better the Devil you know?” (to quote Ms K. Minogue). There is also the Opportunity Cost - if you have been Stopped Out of a great company that is just going through a soggy patch, you will be out of a great stock that will most likely turnaround in a period of months and turn out to be a cracker. My you will be peed off.
I guess it lines up with another concept of mine - “Today’s Loser is tomorrow’s Winner.”
This week’s Investor’s Chronicle (31 Oct - 6 Nov 2014) has an interview with Francis Brooke, the manager of the Troy Income Fund, where he makes the point that Investors should distinguish between Permanent Capital Loss and Temporary Capital Loss - he said the following:
“If you hold a company that is high risk and you suffer too much loss, say 80-90% of the value, you’ll never get that money back. However, temporary capital loss is when the market is down but you’re invested in a high quality consumer goods company such as Unilever (ULVR) or Diageo (DGE) that goes down 10%. You haven’t lost that capital forever and the company will still pay its dividends. You will still get what you wanted from it but you will have more nervous moments than keeping money in the bank.”
These comments hint precisely at my main gripe with Stoplosses - they stop you out on a temporary down move.
There was a recent Mr Bearbull Article in Investor’s Chronicle where he said he was having second thoughts about using Stoplosses on his Income Portfolio. He said he had Backtested over many years and found that using Stoplosses or Not using Stoplosses made very little difference to the overall returns.
Robbie Burns commented within the last year or so that he now takes an approach of buying a stock and selling it almost straightaway if it starts to fall - so he only takes tiny losses. I have not tried this in practice, but it implies your ability to time Entries has got to be Incredible - er, like Robbie’s……….but the problem is that he is an Extraordinary Trader - it is unlikely any of us can emulate him (I would get chilly with no clothes on anyway, but I do like both Tea & Toast and bizarrely I own a BMW z3 !!)
Another intellectual challenge for me is that Robbie is the only successful investor/trader I am aware of who actually uses Stoplosses. Here are some names of hugely successful investors who dismiss the use of Stoplosses - Warren Buffett, Charlie Munger, George Soros, Ken Fisher, Neil Woodford, Evil Knieval, Jim Slater, Mark Slater, Bill Gross, Peter Lynch, Ben Graham, etc.
They all seem to have managed ok without them……..
WheelieDealer’s Approach to Stoplosses
Despite what I have said in the last section, I think there are circumstances where they are a good idea, and I have been known to occasionally use them.
If I am shorting an individual stock, then I normally use a Stoploss - this is because it is extremely High Risk and the Numbers work against you. If you are right, then you can make 100% if the Price falls to Zero from your Sell level. However, if you are wrong, the Upside and the Cost to You is unlimited - the worst case scenario is if a Stock you are Short of gets a Takeover Bid - the share price just rockets and you are stuffed. Even with a Stoploss you might get huge Slippage and take a much higher Loss than you planned for.
The way I look at Stoplosses is that they are a Tool in the Armoury. For instance, there may be a case where you are expecting a certain Event to occur and you want a Big Position but with the Protection of a Stoploss in case things go wrong. For Example, Avanti Communications (AVN) often do Satellite Launches - I have played these every time and made good money - and a Stoploss on a Large Position (especially if Leveraged on a Spreadbet) might be appropriate.
If I ever got utterly daft again - like I did many times in recent years buying sh*tty miners like JLP, AYM, AUE etc. - I like to think I would use a Stoploss. They make a lot of sense on these kind of High Risk stocks where Operational Issues are frequent, Dilution from New Shares is likely and the companies have no control over their End Prices.
I guess my overall comment on Stoplosses would be, “If you have researched a Stock Carefully and Diligently, then why do you need a Stoploss?”
Unless of course, you are a Trader NOT an Investor.
Despite everything I have written above - I Retain the Right to change my mind at any time. In fact, it has often occurred to me that if ever I found that I was failing to consistently hit my yearly target Portfolio Returns, one obvious possible remedy would be to instigate a Stoploss Policy……confused? I am.
* He wasn’t. I made it up. Honest.
Phew, glad that’s over.