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Lesson 10: Stop Loss

The markets are a game of probability. This means that everyone will be wrong sometimes. When a trade does go wrong, there are only two options: to accept the loss and liquidate your position, or go down with the ship. This is why using stop orders is so important.  It’s all about the exit. The sell point actually determines the final outcome of an investment. Even savvy investors have a difficult time deciding when to sell. Many traders take profits quickly but also hold on to losing trades - it's simply human nature. We take profits because it feels good and we try to hide from the discomfort of defeat. We may get nervous and sell a winner too soon — or hold losers far too long.

Some set “mental” stops and then fail to execute them. Others use trailing stops only to find themselves “whipsawed” out of a stock just before it takes off for a big gain. A good exit strategy applied consistently lets profits run while providing downside protection to minimize losses. A properly placed stop order takes care of this problem by acting as insurance against losing too much. In order to work properly, a stop must answer one question: At what price is your opinion wrong? Lets explore my approach to determining stop placement that will help you avoid big draw-downs and reap profits when ripe.

Early on I learned that stops based on a fix percentage do not account for the personality and the potential of certain stocks. For example, you buy a slow change stock like Proctor and Gamble because it is stable and pays a good dividend. But you buy a tech stock like Google for future growth and but expect less stability. So your traditional fixed 5% stop might wipe out 6 months profit for a firm like P&G but for Google that could be a normal range in a week. Using the same trailing fix percentage stop for all your trades, will guarantee either excessive draw-downs or costly whipsaws.

The system of stops I used is called the Chandelier stop, also called a trailing ATR stop. To understand this system you should read this short article on Average True Range and how to build a stop around that.

Here is a short YouTube Video showing the stop and its formula

I recall once working with a programmer who was known in quantitative analysis circles. When I had him code in the Chandelier stop he was confused, at first he thought there was a bug in it, because as the market sold off the stop moved out of the way! Yes it dropped with the stock (look at December 2016 below). But if you think about the way the market works - stocks zigs and zags and one day it zigs and keeps on going - a crash. Well during zigs and zags you need a stop that does not trigger just as things are about to get better. But when the downward momentum is all one way it should trigger then. Well of course a zig zag market is more volatile, it has a bigger ATR range. A falling market does not, it is all one way baby.

What a 3 ATR Chandelier stop does in a volatile market:

Black and Decker above we see a nasty sell off at the end of 2015 and our stop kicks in, however look how much rope our stop gives in July to August 2016. It finally gives up in late October 2016.

But for a more stable equity like a stable ETF you can track for a long time without whipsaw. Here is USMV that looks for low volatility stocks, with the same 3ATR stop we used above. See less whipsaws, more profit.

The point is we all need to "cry uncle" at some point, by enforcing rules over emotion we can face reality when something is not coming back. However the more volatility the more you must let it run, to avoid whipsaws. Reward is tided to risk. If you are going to play with fire, you better be ready to be burned.  They say the trend is your friend, but I think the Chandelier stop has been a better friend to me.

Do Stops Work?
Unfortunately in most cases no. If you program a computer trading system, in a back-test it might make a certain profit. Then add a stop-loss and often it makes less profit, in fact, a stop often will make it totally unprofitable. That is because all stops introduce whipsaws. However a computer paper trading does not care if you recover from a huge downturn, but trust me as a trader you will. So for reasons of human frailty you must have a point you agree to give up and say you were wrong on this trade.

The key to placing stops and staying profitable is to place the stops fairly far away from the normal volatility of the equity you are trading. For example try and cope with the idea that if you plan to hold this for 3 months that is OK to loose all the gains that equity made in the prior month. So if your January low was $12, and the equity is now at $16 when you buy it in February, you better be able to cope with a stop loss at say $11.75 or lower. You also better make sure you believe this equity can hit at least $21 dollars in three months, because your expected profit should outweigh your accepted risk.

Right and Wrong Stops
Most stop advice I have heard is based on dangerous chance taking, like day trading or trading a very leveraged investment like a futures contract. This is a lot like telling a thief that he should carry a gun. Yeah they tell you it might get you out of a situation you should not have gotten into in the first place, or it could make a smaller thing into a very big thing and you could end dead. The stop loss is just part of a series of bad ideas here, you really should not be treating the markets like a casino in the first place and a stop will likely lock-in your mistakes at the worst possible time. 

The right use of a stop is peace of mind. I had market comment reader ask me if she should dump a high flying stock before her one month vacation. I told her to set a stop at about where the stock bottomed 3 months ago and not worry, she had a year's gains under her belt, the worst that could happen is to loose a few months of profit. Not only in that bull market was that really unlikely, but she could enjoy her vacation and know the worst case scenario. As it turned out she had a nice time and found the stock was up 10% when she returned.

Computer or Manual Stops
You can set your stop loss in advance with your broker or you can just have an email alert sent to you to remind you you are done. The automatic stops are a good discipline, in case you are tempted to stay. However in a short term hick-up like a mini "flash crash", or even just a volatile trading day, you can get out when perhaps that was selling low.

In my case I have some wide stops, and I tend to move them up as I "lock in" my profits. But I seldom get a fill on my stops because they are very wide. Often as the story on this equity changes I just pull the trigger and sell to get out, without the stop.

So I would recommend a very wide stop as a matter of good practices, and to help you sleep at night. That said, you really should be selling losers yourself before you get in trouble.