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7-21-00 Page

This Week's Guidepost

Exit Systems #3: Stop-loss: Protecting our capital

1. There are two issues with stops: First, the protection of our capital, the money we invest. Of course, we know there will be both wins and losses in our investing experience. We must include a strategy that lets us hang on to most of our initial investment. Or, how will we get out of a bad trade if it really goes against us? The second issue deals with protecting our profits. We need a strategy from the start to get out when the market turns in our favor. This becomes important as the expected growth of any stock will include pull-backs that we do not need to follow. The first issue, capital protection, will be the message in this guidepost.

2. Stop-loss orders are the easiest way to limit losses. This means we will have clear exit signals to get us out with a predetermined loss of the money we have invested. But wait a minute, we got into this business to make money, not lose it! Of course. But the way we make money is by controlling our losses, not eliminating them. Winning is easy, winning will take care of itself. But losing must be controlled, it must be managed so that our winning trades predominate. There is one certain way to control losses; 1) Always use stops, ALWAYS! 2) Always set up stop strategies before we make the trade!. That is, we should enter a trade only after answering the question; “How will we get out of a bad trade if it really goes against us?” If we buy 100 shares at $56, we needn’t think the entire $5,600 is at risk. Our exit strategy lets us limit our loss at some acceptable level. And that is the purpose of the stop-loss; Protection of Capital!

3. What is an acceptable level? We need to understand the statistical nature of prices in the market. There will always be some level of noise, randomly generated price changes, that we must live with. What we don’t want is to have our loss-cut price at a level where noise will trigger the sell action. We want the drop in price to be real, some down-tick resulting from a non-random action. This illustrates the tough decision we need to make for proper selection of loss-cut price points. If we put the stop too far below the current price, we will lose too much before the sell is triggered. If we put the stop too close to the current price, we will get kicked out for no sound reason. Transaction costs will escalate with unnecessary trades. Where do we find a balance?

4. William J. O’Neil, founder of Investors Business Daily, uses an 8% loss-cut under all conditions. In this case, the maximum risk one is ever subject to is 8%. In the $5,600 investment mentioned earlier, the most we would risk losing would be $448 (plus transaction costs). O’Neil is a Buy & Hold fundamentalist. Other market pundits use percentage stops between 5% and 12%. Another method is to define loss limits in terms of dollars, rather than a percentage. If all a trader can afford to lose is $1,000, he should define a stop loss strategy that gets him out at that point. This extends into money management and how much capital should be staked on each trade, but that is a subject for a later guidepost. At this point, it is far less important where exactly to set our stop-loss, and more critical to have a strategy that we adhere to. Always!

5. A sound exit strategy eliminates the need to make decisions under fire. It also keeps us from selling too soon and losing the benefits of “letting our profits run.” A critical issue we all must deal with is adhering to whatever set of rules we adopt. Why is this such a big issue? Because it is so hard for us to obey the rules. We all, yes, all of us, hope to win, to avoid losses. That means we hold on too long, thinking (hoping) for a turn in our favor. And why not? We live in the most favored land during a most favored period of positive returns and economic boom. Why not hope? Its just bad business! Is the emotion fear or greed? It doesn’t matter. Losers hope, winners stop.

6. Stop-loss: A price below our entry price we will not allow the price to fall without bailing out! We are defining the maximum loss we are willing to take, thus, a stop loss!. There is NO successful trading system that does not define when to get out of a market position at the time of entry. Percentage and dollar stops are common, but the question of how close to place them to the current price requires an understanding of price volatility. Volatility refers to the amount of daily price movement we are likely to encounter in a position. Beta has long been the market’s measure of volatility, which compares the price action of a stock to the price action of the S&P 500 index. If beta is one, it moves exactly with the S&P. That doesn’t help in setting stops, particularly as the market in general becomes more volatile (as reflected in the S&P). On a daily price chart, we can see the volatility as the changes in price between the low and high prices for the day. That is the price bar. All we need to do is find the average difference in price between the high and low for the day and use this as a measure of the noise in the market. Appropriate choice of stop prices depends on how much daily variation we might expect (noise). The next figure shows why Wells Wilder came up with an average true range calculation to help us quantify price volatility. It is more than just the difference between the high and low for the day.

   

7. An artificial price bar chart for 8 days is shown to make the point. Each day shows the high, low, and closing prices on the bars. The values are summarized in the table on the right. I have intentionally shown the difference between each high and low the same, $5. This is to show how price volatility is due to the high-low difference and the price changes that occur from day to day.

   

8. The Average True Range is the greatest of the following: The distance from the days high and low prices
   The distance from today’s high and yesterday’s close
   The distance from yesterday’s close and today’s low.

9. From the previous table, we find in the MAX column (biggest of the three), the largest difference is $8.50 (11.4% of the price), larger than the daily low-high difference. If we use volatility to help set stop prices, we can help avoid setting the stop prices too close to the current price. Recommendations range from using twice the ATR below the price level to three times the ATR. This is an area we can study, using the stocks we trade as examples, to help us define stop-loss triggers.

10. If we enter an order, to sell if the price falls to $X.00, the broker will take that as marching orders to “sell at the market” when the price falls to $X.00. If the market drops catastrophically, the stop-loss will be triggered but the actual sell price can be much lower. This is the downside of using a stop-loss as a protective device. For instance, look at the price chart below on BBOX for a recent example.

    

11. The price had risen most of the year to a high on 7/12/00 at $89.94. It fell the next day to $55.94, with little warning. It would have made little difference whether we had our stop loss at 5% or 12%. By the time the market order filled, the price would have been somewhere around $55. So what good did the stop-loss do us? Point: Examples like this can always be found to discredit the value of a stop loss. They don’t occur frequently. The money we will protect (save) from diligent use of stops will always outweigh what we might lose on a plunge like BBOX. Next week we will revisit BBOX as we cover exits to protect our trading profits. Stay tuned.
    Understanding:

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