By Martin Tillier
A couple of weeks ago, I wrote about reassessing risk and how, given the current interest rate environment, risk is not all bad. We cannot avoid it if we are to make money, so we must learn to limit and control it. This is something that traders do every day, and is one of the most important things that investors can, and should learn from traders.
There are many ways to limit and control risk. Diversification and hedging spring to mind, but using stop-losses can be the most simple and effective method. Before we go any further, we should define ‘stop-loss’. If you are an old hand, forgive me, but I believe that using unexplained jargon is one of the most annoying traits of financial professionals. A stop-loss order does exactly what it says; it gives a way to stop a loss before it becomes too big. It is an order placed to close a position if a certain level is reached. They are usually placed at the time, or soon after, the initial order is executed. If you buy a stock the stop loss order would be to sell at a pre-determined, lower level. Let’s look at an example (Research In Motion: NASDAQ, Ticker RIMM) where it would have helped to have a realistic stop-loss in place.
This looks at first glance like a straight line down, but there are plenty of false bottoms. Back in early June, for example, the proprietary indicators at VectorVest (whose chart this is) may have been screaming sell, but there were plenty of pundits who believed that hesitation around the $10 level meant the bottom had been found. If you had believed that and bought at that level without the protection of a stop-loss order you would now be looking at a 30% loss and left praying for an unlikely bounce. Not so much ’buy and hold’ as ‘hold and hope.’ Most traders would have protected themselves against being wrong with a simple stop-loss. In this case, a break below $9 would indicate that the theory was wrong, so that would be the logical level to use. You would have lost around 10% of your initial investment and moved on to look for a profitable position.
Twenty years in the world’s financial markets have taught me three simple rules about stop-loss orders:
1. Actually Place The Order: This may seem obvious, but setting a level in the mind has resulted in spectacular losses for me and anybody who has ever traded. The human mind is a funny thing. That obvious level to cut can easily become an obvious level to buy more, and average the position. Most online brokerages make it simple to place a stop-loss order with only a few clicks, and doing it at the time you make the initial trade is a good habit to get into.
2. Don’t Use Round Numbers: People are drawn to round numbers and, believe me, floor traders know it. In the example of RIMM above, setting a stop at $9.00 exactly wouldn’t have mattered, but it can. Stocks will often touch a round number or obvious chart point, trade a few cents below, then jump back up. It isn’t a coincidence. Taking a loss of a few pennies more is worth it to eliminate that risk. Again using the scenario above, I would have set a stop at $8.91 and taken an extra 1% loss to protect against a false push down.
3. Don’t Place A Stop-Loss Too Close: Lots of small losses are as bad as one big one. How close is too close depends on several things. First and foremost, it depends on your own pain threshold. This could be limited by the amount you can afford to lose, your attitude toward taking a loss or both. The nature of the investment is also a factor. Setting a tight stop for a volatile stock is asking for trouble, and setting one too far away for something stable is pointless.
There is no magic formula for making money, but it is impossible to make money in the markets without taking on risk. Stop-loss orders are an effective way to control that risk. Understanding these three simple rules will help you to use them successfully.
Martin Tillier has been dragged, kicking and screaming into the 21st century, and can now be followed on Twitter @MartinTillier and Facebook Martin Tillier.