Tuesday, May 27, 2008

Whoa Nelly! Setting Stops

From time to time in my blog I've mentioned the importance of setting stops. In the articles I wrote about the Turtle trading system (see May 14-21 blogs), we saw that setting stop-losses was an integral part of their system. They defined their stops based on volatility and they knew precisely at the point of purchase what their stops would be for each trade. This is just sound money management practice and setting the appropriate stop can make all the difference between portfolio profit and loss.

If you don't like the Turtles' method of defining stops based on a stock's volatility, are there are other methods that can be used effectively? That's the question I'll be tackling in the next few blogs, but first I'd like to give an overview of the different types of stops that are the most popular among investors.

The Gain/Loss Stop
This is the easiest stop to understand. You define the amount of profit (gain) at which you'll sell your stock and also define the maximum loss you're willing to take. The amount that you specify is up to you. In general, a long-term investor will probably specify a larger loss amount than a short- term investor because he or she wants to capture long-term gains and is more willing to ride out short-term market fluctuations.

There are two different stop-losses to consider: One is the stop-loss per trade and the other is a stop-loss on the overall portfolio. One popular method of setting both is the 2%/6% system. In this method, you would define the stop-loss per trade as 2% of your overall portfolio value. If, during a month, your overall portfolio losses exceed 6% , then you would exit all your positions and stop trading for the rest of the month. The next month you would start again but with an overall lower position value and stop-loss amount.

Let's consider an example. Say you have $100,000 at the beginning of May with which to trade. If you abide by the 2% rule, then you'll be limited to trading only 3 positions, but if you limit your risk per trade to 1%, then you're allowed to trade up to 6 positions. If, say, May isn't going so well for you and your portfolio loss reaches or exceeds $6000, then you would exit all your positions and stay out of the market until June. The good point about this system is that the time you spend out of the market will give you an opportunity to analyze what went wrong with your trades and also to identify new potentially winning trades for next month. Personally, I know very traders who use this system but it could be just the ticket for the novice investor who is unsure of his trading skills. Not only does this system limit damage to one's portfolio but also to one's confidence.

The Ratchet Stop
A ratchet stop is one whereby the stop-loss is adjusted upwards as the stock moves up (or downward in the case of short positions). The ratchet stop is never adjusted downwards (in the case of long positions) and if the stock happens to trade under its ratchet stop price, the stock is sold. The problem with this method is that it can lead to whip-sawing and my simulations (which I'll be presenting in the next few days) show that it's an inferior method of setting stop-losses.

The Trailing Stop
The trailing stop is probably one of the most common methods of setting stop-losses. A trailing stop maintains a stop-loss order at certain percentage below the market price of a stock (or above it for short positions). For example, if you have a 10% trailing stop on a stock trading at $100/share, then your stop-loss point is $90. (Note that most brokers will let you set trailing stop-losses.) This method sounds easy, but there are a few points to keep in mind.

The first point is determining how much of a trailing stop is appropriate? That depends on the volatility of the stock in question and the length of time it's been trending. Initially, you may want to set a very loose stop, say 20%. This will keep you from being taken out of the trade too soon. As the stock begins to move in your favor, you can tighten up the stop. If it's been in a significant uptrend (for long positions) for a long time, you may wish to tighten up your stop even further to protect your profit.

The second point is what is the best percentage to use? More volatile stocks, like lower priced stocks, require a larger trailing stop while less volatile stocks such as large-cap companies require a smaller stop. In upcoming blogs, we'll see which trailing stops are the most appropriate for these cases.

The Parabolic SAR
The parabolic SAR (an acronym for “stop and reverse”) is an indicator plotted on a price chart. Many charting services provide this feature and it's used as a tool to set stops. The parabolic SAR is a mathematical formula that calculates the stop-loss levels for both sides of the market. It moves incrementally in a parabolic (curved) fashion each day along with changes in stock price. When the price intersects the parabolic SAR, the position is stopped out and the other side of the trade can be taken. This is a really good method for setting stops except in two instances--it's ineffective in choppy and non-trending markets. Choppy markets leads to a lot of whip-sawing. In non-trending markets, your stop may never be reached and your profits won't be locked in. Note that if you can't watch the markets everyday, this method is not for you since I don't know of a brokerage firm who will accept stop-loss orders based on the parabolic SAR.

Other Stop-Loss Methods
In addition to the above methods, there are other technical factors to consider. Although some of these rely on the trader's technical expertise and experience, they're well worth the effort to learn and are not that difficult to understand. The following considerations refer to long positions but the reverse logic can be applied to shorts as well.
1. Long-term trend break. If a long-term uptrend line is broken or it breaks a major support level on larger than average volume, consider selling all or part of your position. This is especially true of your stock is showing a head and shoulders break.
2. One day price drop. If your stock has risen substantially and makes a large drop, consider exiting all or part of your position. (This is where experience comes into play.)
3. Sell-off on heavy volume. If your stock has been selling off on heavier than normal volume, consider selling all or part of your position.
4. Staying below its 10 day moving average. If a stock persists in staying below its 10 day moving average, then consider lightening up your position or exiting.
5. Moving average cross-overs. If the stock's 50 day moving average moves below its 100 or 200 day moving average, it's time to get out.

Setting up stops is an integral and important aspect of proper portfolio management. In upcoming blogs we'll be looking at what types of stops provide maximum portfolio returns under various conditions. Don't stop now!

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