Wednesday, October 10, 2012

Why You Need a Stop Loss (and the Proper Way to Place One)

The big debate in the financial industry among investors and traders is whether or not one should use a stop loss. Some say it is advisable to do so, because it will prevent your losses from growing and compounding into a more deadly problem. Others say you shouldn't - "you should just hang in there and wait for the market to return - if you use a stop loss, you might get stopped out at the worst time possible". 
I believe that one MUST use a stop loss. However, my method of placing a stop loss is a little different from that of others.

Why You Need a Stop Loss

A stop loss has two very important purposes:
  1. Using a stop loss properly is the ONLY way to manage risk. Some say that you can manage risk by diversifying - I do not believe that is true, because true diversification is no different than buying an index wide ETF (e.g. S&P 500 ETF). Thus, stop losses help you manage risk by only permitting your losses to go so far - once the losses exceed that limit, the stop loss will automatically trigger and stop your "blood loss". 
  2. When I invest, I like to wait for the fundamentals, technicals, and political policy to all line up in one direction (the market direction is easiest to predict when this happens). However, if I'm 99% sure that my market prediction is correct, there still is a 1% chance that your prediction was wrong. The first thing one learns from Risk Management in university/college is to never, never put yourself in a live or die situation, because you just might die. Thus, without a stop loss, your losses could potentially wipe you out - without any capital, you can't make a comeback in the markets. 
  3. It can validate whether the fundamentals you analyzed were correct or wrong (e.g. you believed the fundamentals of the market were strong, but if the market hits your stop loss, it invalidates that belief). 

To summarize, the only way to properly manage risk after you've initiated a position is to use a stop loss. So how does one set up a stop loss correctly? 

The Incorrect Way to Setup a Stop Loss

Most people make this mistake - they do 1 of 2 things:
  1. Many investor and traders like to place their stop loss near or at whole numbers, such as 10's, 100's, 1000's, etc. Do not do this! nowadays, many big traders and fund managers can buy data that shows where the majority of stop losses are. They'll purposely (artificially) trigger that stop loss, forcing you to cover your position, which yields them handsome profits. 
  2. Many others like to place their stop losses at their maximum pain threshold. For example, if Tom is willing to lose a maximum of 10% on any single position, he will place his stop loss at 10% below the market price he opened his position at. This is wrong, which will become evident later. 

In short, you cannot use the above conventional ways of using stop losses because nowadays, the market experiences such extreme swings (thanks to investment models, computer traders, and the consolidation of market capital) that the extreme swings often touch the stop loss, after which the market swings the opposite way. 

The Correct Way to Setup a Stop Loss

When I invest, I create different scenarios. If this happens, then it validates Scenario A, and this should happen as as consequent. If the market then moves this way, then it validates Scenario B, and this should follow as a consequent. Etc. Many times, if something changes, the market will have switched from your Scenario A to Scenario B. So here's how you set up a stop loss:
  1. Place the stop order at a market price that, should the market reach that price, your market prediction would be invalidated (eg Scenario A) and you must change your prediction to a different scenario (e.g. Scenario B). 

Tony blogs about his financial thoughts at Intangible Investor, a site dedicated to analyzing the fundamentals of the biggest U.S. and international stocks.

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