Stop Losses the Right Way, Where, and How

When volatility is high and stocks whipsaw up and down, how do you know where to place a stop loss?  Is there a right distance from the stock’s price to place the stop loss?  Is there a correct procedure to determine where to put it?  As the stock approaches the stop loss, you may get nervous and want to cancel the stop loss so the stock will not be sold.  How do you keep from selling too soon or from getting “psyched” out of a good stop loss (as when emotions cause a person to second-guess reason) and staying with a bad position too long?  The answer to the first questions is related to the answer to the last question.  If your stop loss placement is mathematically sound and based on the laws of probability, and you truly understand and accept what that means, you won’t be as easily psyched out.  That is a major advantage of a volatility stop loss.  It is based on mathematically determined significance.  The same can be said for stop losses based on support levels.  A breakdown through a support level is an event of significance. 

Getting “psyched out” is a psychological problem that often gets in the way of disciplined investing. Once, when I was managing accounts on behalf of our advisory firm, a client called and asked if it wouldn't be a good idea to have stop-losses in place to protect us if any of our stocks plunged. I had just taken the positions and had not yet placed the stops. At the time, I agreed that stop-losses would be appropriate. I had been teaching clients for many months about the need to implement a stop loss for every position. The lessons apparently were sinking in.  The feedback I was getting from clients suggested that they were in agreement about the need to sell quickly when a stock declines more than is characteristic for the stock or when it plunged through a pre-determined level of support.  However, when one of those stop-losses was triggered, a client called who wanted to know why I sold when the stock was low. This person wanted to wait for the stock to rebound before selling.  This is a form of seller’s remorse.  The client agreed that selling early while the loss was still small was the best procedure.  However, when it came down to locking in a small loss, the individual was conflicted. He agreed with the strategy in theory but not with its implementation.  Nobody likes to take a loss.  Here is a special Bulletin: any person who does not use stop losses is begging to be taught a lesson in risk control.  The market will oblige.

There are those who firmly believe in risk control but get "psyched out" of their discipline by the market.  For example, a person might try to use a stop-loss but then give up on stop-losses altogether when that stop is triggered just before the stock resumes its climb.  The root of the stop-loss "problem" is the uncertainty that stems from most people’s lack of knowledge regarding proper stop placement. They either place the stop too far away from the stock, or they place it so close that it is virtually certain to be triggered.

If a stock repeatedly rebounds after a decline to $50, then there is support at $50.  That means there is demand at that level.  If the stock drops through that price, it means the selling was severe enough that it overwhelmed all the buyers at that level.  That is a significant event.  Just below that buying support is where a stop loss belongs.  If the stock breaks through that support, it is destined to go lower.  Stockdisciplines.com traders look for significant events like this and they also look for events that are statistically significant.  That is, when stock behavior is outside the normal distribution of excursions for that stock, it is considered significant.  Here is an example.  If it is normal for a stock to make an excursion of up to 2% on either side of a 50-day moving average within a period of 100 days, then an excursion of 3% below the moving average would be significant.  Refusing to sell on a significant negative event will not stop the decline.  It will only cost you money.  People do not like to admit they are wrong.  They cling to the hope that the stock will eventually live up to expectations.

Assume that the distribution of a stock’s daily low prices about its moving average indicates that downward price excursions equal to or greater than 4% below the stock’s moving average occur only once in 200 days.  Assume also that you are trying to capture the gains achieved by trends that last about 100 days.  A spike of 4% below the moving average would be well outside the probability envelope of your investment time-horizon (the stock is deviating much more than is “normal” for the stock).   That kind of price excursion would be a significant event.  That is where a stop loss belongs.  It would be foolish to keep holding the stock and hoping for a recovery.  To do so would be blatant evidence of a lack of discipline.  A disciplined trader would sell immediately.  Even if the trader should later decide to repurchase a stock recently sold, the decision will be based on much greater clarity of thought and with more objectivity after it is sold than the decision to retain a stock that is already in the portfolio.

Of course, the caller mentioned above knew the stock was at a low by hindsight. If the stock had continued to fall, the caller would have thought the move was well-timed. The point is that at any given moment one can never be 100% sure what a stock will do next.  One of the biggest errors a trader or investor can make is to confuse what is with what is hoped for or with what has been.  The best traders always keep their eyes on the present. Acting on what is (on what the facts actually are in the present) sometimes means relinquishing your preconceptions about what a stock ought to do.  If a stock has broken through support, forget about your expectations for the stock.  The company may be great and its product may be wonderful, but its stock is for some other time.     

Copyright 2009, by Stock Disciplines, LLC. a.k.a. StockDisciplines.com

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