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8-4-00 Page

Exit Systems #4: Stop-loss: Protecting our profit

1. Last week we covered the first issue with stops: Protection of capital, the money we invest. We will extend that basic strategy this week to the protection of our profits. In its most basic form, as the price of our stock increases, we can simply move the stop loss higher. A downturn in the price will trigger the stop and a sell order will be executed. The important question this week is just how close to the price should we set our stop?

2. We learned last week there is a hazard in setting stops too close to the current price. The variation that takes place in the market can trigger a stop in the face of market “noise,” not a real down-turn in price. We talked about one measure of price volatility, Wilder’s Average True Range (ATR), and have included this measure on each or our picks on the Pro-fundity Page. We will use this measure a bit later in our discussion.

3. For a sound opinion on setting stops for profit-protection, I quote from Don Worden, founder of Telechart 2000 and chartist extraordinaire. “This one is so simple and obvious I'm almost ashamed to reveal it. It can and probably should used as a supplement to all other exit strategies and all combinations of exit strategies. After you are once 10 percent ahead, don't ever give back more than 66 percent of your profit. After you are once 20 percent ahead, don't give back more than half your profit. After you are 50 percent ahead, don't give back more than a third of your profit.”

4. Let’s dissect Worden’s suggestion for understanding. Consider the following table which lists three positions in a stock whose initial purchase price was $50.00 per share. Each of the three scenarios mentioned by Worden are included; ahead by 10%, 20% and 50%. The stop loss for each case is shown in the next to last column. These values would provide the profit protection prescribed.

   

5. I find it difficult to deal with the many conditions we might encounter. Such as, where do we set the stop if we are 15% ahead? Or 28%, etc., etc. To help simplify, I’ve included in the last column of the table what percent of the current price the stop represents. Interestingly, these percentages are not too different. In fact, if we set our profit-protection stop at 94% of the current price no matter how much our profit, the following results.

   

6. The comparison to the previous stops show the differences become greater the further our profit has increased. The danger here is in getting the stop too close to the current price. One way out of this dilemma is to use the 94% stop until we hit 20% profit, then revert to a flat 90% stop. The following results.

   

7. The differences are now manageable and this provides us with a simple guideline to follow: 1. If the prices increases putting us 10% ahead, set a profit-protection stop at 94% of current price.
   2. When the price increases putting us 20% ahead, set the profit-protection stop at 90% of the current price.

8. After our discussion last week, how does this set of guidelines track in the face of volatility and market noise? The answer is we need to consider the level of noise to see if we are on or off-track. The next table is taken from the Pro-fundity Page showing the last-day price and volatility measures (ATR). We’ve added two rows at the bottom showing the percentage of current price the volatility represents.

   

9. For instance, look at the first ticker, BTUI. If we held this stock and it is 20% above our initial purchase price, would 90% be a good profit-protection stop? We need to check its volatility. The 15 day ATR is 7l.2% of its current price. This means the normal variation might be above or below its current price within this 7.2% window. Half this range is above and half below the current price, or between $10.49 and $11.27 (the difference, $0.78, is 7.2% of the current price). This low price, $10.49, is higher than the 90% stop ($10.88x.9 = $9.79). Shouldn’t be a problem. However, if we use twice the ATR as a protection from being whipsawed by market noise (per last week’s discussion), then this range would widen from $10.10 to $11.66. This is still a respectable amount above the 90% profit-protection stop.

10. We’ve developed some sound guidelines for the protection of profit. This is a companion to the strategies we developed last week for protection of capital. Play around with these numbers to come up with the set that makes you most comfortable. But come up with a set of rules that you adhere to! It is these rules that will hold your emotions at bay. A lot is said about fear and greed. The one emotion that gets in the way the most often, however, is Hope! Why? Because we hope the stock will go back up, we hope current downturn is an anomaly, we hope the rosy earnings estimate will encourage some institution to wake up and get on board,.... Hope is not bad. That is, if it does not get in our way and prevent us from following the set of stop guidelines we have decided to make an essential part of our investing and/or trading strategy. We will fine-tune possibilities in the coming Guideposts, helping you select what works best for you. Stay tuned.
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