Let’s talk about stop losses and how to set them.

In a previous article I said that the only thing we have any control over in trading is how much money we are prepared to lose. The way we manage this risk is by using a stop loss. The name says it all – its purpose is to stop your losses at a pre-determined point.

You may have heard the expression ‘cut your losses short and let your profits run’. A stop loss is the way we cut our losses short. However it is one of the hardest things psychologically to do in trading. In fact your emotions and ego will scream at you to try and make you avoid taking a loss. Taking a loss means admitting you were wrong. This is very hard for a lot of traders to do. Consider the following chart:

babcock & brown chart

Click here to open chart in a new tab.

This (now delisted equity, BNB:ASX) peaked on 18th June 2007 at $33.84 whereupon it commenced a slide down over the cliff and last price was $0.325 on 7th Jan 2009.

The thing to note here is that it took 18 months to completely collapse and there were a lot of rallies and declines as it went down. There were many opportunities for a smart investor who used a stop loss to get out of this position.

Investors who purchased this instrument during its decline followed the adage that it’s worth a lot more ($33.84) so it’s a bargain at $24! It will recover! It’s going down so I will buy more! I’m going to make a killing here! I better tell all my friends about this.

For some reason I can’t find any analyst recommendations on the internet however at a guess they typically would have had it as a ‘buy’ or ‘hold’ all the way down’.

A prudent investor who cared about capital appreciation would not have lost their shirt with this stock. Consider the following chart:

Click here to open chart in a new tab.

The red line represents a 5 x multiple of a 14 day ATR. In other words, the software is calculating the Average True Range (ATR) of this stock price averaged over 14 days and multiplying it by 5.

The ‘True Range‘ today is defined as the greatest of the following:

Either today’s high – today’s low
OR the absolute value of today’s high – yesterday’s close
OR the absolute value of today’s low – yesterday’s close

The average true range is a moving average of these true ranges – in this case over 14 days.

Note that using the ATR to set stops is only one of a myriad of ways to set a stop. What you decide to use is purely up to you. Just make sure you use something and stick to it. Using your gut feel is NOT ‘something’!

So why use a 5 x ATR? No reason! It’s really a matter of whatever fits in with your psychology.

The issue here is that you want to be able to have some point at which the market convinces you that you have made a mistake and close the position. If you selected say a 1 x ATR multiple, that is the average amount you would expect the instrument to move in one day. This will quite likely (more than likely) bounce you out of a position in the next day which is not really what you want to happen. This is called a tight stop. Our goal as traders is to catch the the big moves and you will rarely be able to do that if you use tight stops.

Some traders when they enter a trade will use a different ATR value – they might use a 3 x multiple upon entry to the trade and then when the price reaches break-even, they may widen their stop to 5 x but this is purely a personal decision!

In the chart, you can see a number of occasions when the share price broke through the 5 x ATR and then continued to go up. It happens and it is maddening when it does to se price stop you out and for the instrument to take off in the direction of your trade. If you get another signal you can always get back in. In any case, as the price was declining, if you had used a stop from entry your losses would be very limited.

The way I trade is I will always have determined my stop level and I will place this as a stop market order good-till-cancelled for every position I enter so I don’t have to even think about it! Don’t leave this to chance because your psychology will do everything it can to keep you in a losing position (and to take you out early in a winning trade – you never get broke taking a profit right?)

The stop is set in my software so it ratchets up the level every day/week according to the current ATR. It will never back off and go down – it only goes up. When price hits my stop, the broker automatically converts my good-till-cancelled order to a market order and closes the position.

This will also mean that you will give back 5 x ATR as a donation to the market if you use this stop to determine when to exit a trade. You could also exit on a technical signal but you need hard and fast consistent triggers in your trading plan to control exactly under what circumstances you will be out of a trade. Don’t leave it up to your ego!

The stop loss is also used to determine how many or how much of an instrument you should purchase. This in turn determines how much you are prepared to lose on a trade.

Say an share’s price is $20.00 and the ATR(14) is $1. Let’s say you are prepared to risk $500 on each trade (usually a percentage of your account). So how many/much can you purchase?

Well if you are entering at a 3 x ATR, your risk per share would be $3. If you want to risk $500 on the trade you could buy 500/3 = 166 shares. 166 shares would cost you $3,320. You would place your stop loss at $20-$3=$17.

More on this in Position Sizing article.



Originally posted 2017-05-04 13:37:58.