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The art of stop-losses

Michael Taylor explains how to strip out our biases and emotions from selling decisions
The art of stop-losses

One of the biggest problems traders have aside from position sizing is selling. This is due to the complex emotions and in-built biases we as humans suffer from. Following the herd served us well when we needed to be aware of predators and stick together; however, rarely does this need for confirmation bias translate to success in the stock market.

It is natural to want to avoid loss, but we can beat back the chimp by putting in a system in advance before placing the trade. Getting into the habit of knowing where we are going to get out of the trade removes the influence of the heat of the market, and all the flashing lights and screens, and it just becomes a case of simple execution. We decide our levels to get out of the trade, or take our profits, and then when those levels are hit – we pull the trigger. Indecision kills gains. Regret prevents gains.

Indecision: Should I sell? Should I buy? Should I hold?

Regret: I should’ve sold. I should’ve bought. I should’ve held.

These two emotions will wreak havoc on our P&L – but only if we let them.

 

The problem with physical stops

If you’ve ever placed a stop in the market, no doubt you will have experienced that your stop is triggered, and the price instantly reverses leaving you printing the low of the day. It’s certainly happened to me. There is a debate over whether market makers can or cannot see stops. But think about it this way: if you were a market maker, and you know that plenty of punters will be putting their stops on the support line and just below in the support zone – would you drive the price down to stop them out for cheap stock to sell for a quick profit to others? Of course you would. Why would you not?

Anyone looking at a chart can see where the obvious stop losses are likely to be, and those with the power to move the market can easily gun those stops down. Physical stops are better than no stop for those without the discipline or time to execute their mental stops, but for the above reason the best option is to not use physical and only use mental stops.

 

The dangers of mental stops

While mental stops mean that we avoid having our positions physically taken out, we must be careful of our tendency as humans to be loss-averse.

It’s always tempting to move our stops a bit lower to give us a higher chance of staying in the trade, but what is to stop us moving our mental stop lower still until we are now way past our original intended exit price?

The danger of this is that if we do move our stop lower, and we do stay in the trade, then we have now been rewarded for what is a bad habit. This makes it even more likely for us to do it the next time as our recency bias places emphasis on the most recent result! We forget the times it didn’t work, and think only about our last success. The three most dangerous words in stop placement are “just this once”. We should set our stop losses outside of market hours to strip out the emotion, and be disciplined enough to stick to them.

 

Support zones, not support levels

If we think about placing our stops, it is clear that if we put our stock bang on the support level then we are asking for our position to be flushed out. Therefore, we need to place our stop away from the obvious stop loss liquidity, but not too far that we are now increasing our risk on the trade. We covered position sizing for risk previously, which allows us to decrease our position size, and widen our stop, and this can increase our chances of staying in the trade.

Looking at the recent chart of ASOS (ASC) below, we can see how the stops were taken out below the support level only for the stock to then reverse and rebound.

The beauty of the stop loss liquidity is that should other traders have their positions cleaned out, we can take advantage of this by taking the other side of the trade. We now have a much more attractive risk/reward ratio purely by entering the trade at the closest point where we can afford to be wrong.  

Our goal as traders is to get ourselves into trades where we can deploy good risk/reward management and repeat this edge as frequently as possible.

As well as placing our stops outside of the obvious support stop-loss liquidity levels, we can also take advantage of a technique where we break our position down into several micro-positions, and increase our chances of staying in the trade.

 

Staggered stops

An advanced method of staying in the trade is to split our stop placement up into three parts. While this may mean we are stopped out quicker in part of our position, we have a much higher chance of staying in the trade.

For example, let us assume that we wish to trade a £12,000 position in AB Dynamics (ABDP) which trades on the Aim 100 Index.

We want to trade the breakout of the recent high, so we will enter the trade at 2,720p.

We are trading momentum here, and so it is important that we are quick to kill the trade if the expected momentum doesn’t play out for us.

Using a stop of 10 per cent here would give us a level of 2,448p to hit the bid and get out, which we can see is just below the 50 EMA – a period that has twice seen stop losses taken out only for the stock to rebound. We want to maximise our chances of staying in this trade and give ourselves the best possible chance to make a profit, and so we can see in this timeframe that the price has not traded below the 100 EMA (exponential moving average).

If our maximum risk on the trade is 10 per cent it is likely we are going to be stopped out. However, we are only willing to risk our consistent amount of £1,200 on a £12,000 position. So, we halve our position down to £6,000. Our stop can now be 20 per cent and we have adjusted our position for risk.

We would still prefer a wider stop, so that we can increase our probability on the trade. But decreasing position size also decreases future returns. We now break our position into three.

AB Dynamics trade position:

£2,000 with a 15 per cent stop = £300

£2,000 with a 20 per cent stop = £400

£2,000 with a 25 per cent stop = £500

Total risk employed on the trade: £1,200 What we have now done is given a tighter stop on part of the position to allow us to have an even wider stop position on another part of the same trade. The advantage here is that our risk remains constant but the probability of some of the position staying in the trade has increased – we now have a higher chance of making money for the same amount of risk. This is the goal of staggered stops, to maintain exposure to the stock without being fully knocked out of the position.

This works in volatile stocks and stocks where the price is extended and may retrace significantly, and even low volume and low volatility stocks. As traders, we want to get ourselves into these positions where we increase our potential of banking cash and building our P&L.

We can see on the chart that with our 20 per cent stop and even our 25 per cent stop we now know that if these are taken out then this is definite confirmation that the price action has changed and we are right to exit the position.

One disadvantage of staggering stops is that it does increase trading commissions thrice – however, letting trading fees dictate our trading is not a great idea. They are a necessary cost of doing business. 

 

Should we move our stop?

Placing a stop is the first decision we should make when placing a trade, but this did not cover where to move our stops as our position advances. If we are 50 per cent up in a trade, to have our original stop would mean giving back all of that paper profit and more. Clearly, we need a strategy to protect our profits but also give the trade room to breathe.

There has been some research done on stop loss rules. One paper, Performance of stop-loss rules vs. buy and hold strategy, was published in 2009.[1] They compared both normal and trailing stop-loss levels from 5 per cent to 55 per cent over an 11-year period from January 1998 to April 2009 (which covered both dotcom and the 2008 financial crisis) using a buy-and-hold strategy on the Stockholm 30 Index.

 

Trailing stop losses

Bergsveinn Snorrason and Garib Yusupov found that the only stop-loss level that performed worse than the buy and hold strategy was the trailing 5 per cent level. This makes sense as the risk/reward ratio is vastly out of proportion, and is a good reminder for traders to always be sensible when picking risk/reward ratios.  

The best performing trailing stop loss was the 20 per cent level. This allowed stocks to retrace and follow the trend – suggesting that if we want to think long term and capture trends we should consider a wider stop around 20 per cent.

Traditional stop losses

The researchers found that every single stop loss from the 5 per cent to the 55 per cent produced better returns than the buy and hold strategy. This is clear evidence that whether your position is a trade or an investment, a stop loss should be used because it achieves better portfolio performance. For traditional stop losses it was found that the 10 per cent level was the best closely followed by the 15 per cent. Of course, we have to consider that this research was completed only using stocks that consists of the 30 largest companies in Sweden. We cannot simply extrapolate these results to the UK market, as many private investors invest on Aim and in smaller companies that are below £1 billion market cap. Sometimes the spreads can be as wide as 10 per cent (or wider) so a 10 per cent stop loss would clearly not be the best strategy.

The study found conclusively that trailing stop losses were better, which makes sense as the risk/reward ratio is constantly evolving as the stock moves. However, this only works if we are disciplined to not move our stop losses down as the price comes dangerously towards our exit.

 

Stop-losses on small caps

Historically, small cap stocks have posted the more impressive returns and so it makes sense that many Investors Chronicle readers who build their own portfolios choose to own stocks of this size. The benefit of this size is that small caps are much more correlated to their own success as a business rather than the macroeconomic events that can have seismic shifts on larger stocks. This is because they are able to operate in a much nimbler manner and be more efficient and effective in reacting to change.

The case for small caps is strong, but with that extra reward comes extra volatility. The illiquidity in some stocks means that a sell of just a few hundred pounds can easily tick down 5 per cent and knock £500,000 from the market cap! Selling can lead to more selling as other punters unload positions, and it is not uncommon for a small cap stock to gyrate in 30 per cent-plus movements as much of the dealing that goes through small cap stocks is private investors, and not institutions.

These market caps then are illusory. They are not real. If we cannot sell significant amounts of stock without shifting the price, then it is not a hard market cap, and it is a valuation that is constantly up for debate.

I am a believer that we should not hold more than the daily average volume of a stock, and that this should be an absolute maximum. The reason being that in a liquidity event to the downside, the trade becomes a crowded exit. This leads to slippage on any stops as the price can even gap down through the stop and not being triggered.

 

Slicing

Top-slicing is a method outlined in The Art of Execution – an excellent book which looks at all the decisions of some of the world’s best money managers. The ‘Connoisseurs’ were a group of investors that ran their winners, taking small profits along the way to enjoy like a fine wine.

This method can be great for one’s nerves, as profit is not profit until it’s banked. Derisking on the way up means that should any bad news come then we have already been taking gains along the journey.

Looking at the chart of PPHE Hotel (PPH), we can see that despite the volatility of the stock, using the 200 exponential moving average as the final stop for a position here would’ve kept one in the trend for several years.

We could’ve broken the position down into several micro-positions and had various moving averages as stops. This again takes away the emotion and it becomes automatic. Should the stock have had a bad profit warning we don’t need to worry – we have already created our plan and it becomes a case of putting it into action.

There is no exact science on setting stop losses. It all comes down to the risk we are willing to take in exchange for the reward on offer. Using a wider stop definitely allows more volatility to occur and the chance of staying in the trend for longer, but many investors may not be comfortable with that volatility. Everyone loves volatility when a stock is rising, but when it is to the downside they don’t feel the same way.

Nathan Rothschild is said to have been quoted: “My biggest mistake is that I always sell too soon”. The goal should never be to print the top, but to manage our risk accordingly and over time let that edge bring us profits.

 

[1] Snorrason, B., & Yusupov, G. (2019). PERFORMANCE OF STOP-LOSS RULES VS. BUY-AND-HOLD STRATEGY. [online] Lund University. Available at: http://www.lunduniversity.lu.se/lup/publication/1474565 [Accessed 28 Jul. 2019].