Stop Losses and Risk Management

loss-aversion-by-carl-richards

Image source: http://smartforexlearning.com/the-art-of-cutting-losses-letting-winners-run/

“It can’t go any lower” – Famous last words

Almost all traders can attest to this. They take a trade, and it immediately goes against them. Or even worse, the trade was profitable for a while, and then all of a sudden something bad happens and the stock turns. Maybe they had a stop loss in place, but as the price approached it, they kept adjusting it down. Even worse, maybe they removed the stop loss altogether.

The stock was at 50, now it’s at 45. You think to yourself: “It can’t go any lower.

It gets cheaper and cheaper. You decide to average down and buy more shares at a lower price, thus reducing your average cost.

The stock goes down to 40. You think to yourself: “No worries, I’ll just baghold and switch my strategy from swing trading to position trading.”

No matter what happens here, you lose.

The worst thing that can happen is positive reinforcement. The stock moves back to 50 and you sell for a profit. You think to yourself that you are really smart and did the right thing not to sell for a loss earlier. This reinforces bad habits which will end up wiping out your account in the future.

Another scenario is that the stock keeps dropping, and at some point, you decide you’ve had enough and you sell the stock for a massive loss. Not only did you take a huge hit to your account balance, but you have damaged you psychology, which is extremely important in trading. There is also something called volatility drag, which means that it takes a higher percentage gain to get back what you lost.

Here’s an example. Say you have $100. You take a big loss and lose 20% of your $100 so now you are at $80. You then proceed to make a great trade and make 20%. Are you back at $100?

No, you are only at $96. In this case, although you made the same percentage gain on both trades (20% each), you ended up with 4% less money (100-96 = 4).


Remember that the pain from losses is always more painful than the happiness gained from making money. That’s just how humans are wired. The reason why we use stop-losses is to limit emotional decision making. We put in the automatic sell order so that we can sleep well at night without worrying about losing our shirts the next day.

The best traders all have one trait in common: they hate losing money. Afterall, these famous traders have a valid argument. If you lose all your money, you can no longer trade. The general guideline is to never risk more than 5% of your account on any one trade, although most professional traders recommend a risk between .5%-2% of your account per trade.

*Very Important*: Remember that the risk you take is a percentage of your total account value, not the percentage change of the stock price.

Below are some proper ways to use stop losses.

  1. Make sure your stop loss isn’t too close to the current stock price because you will be prone to random fluctuations that will execute your stop loss. A good guideline is to think about where everyone else puts their stop losses, and avoid placing your stop there.
  2. You can also use a volatility stop by placing a stop loss at a distance two times the 14 day ATR (average true range). On stockcharts.com, click on “indicators” and select “Average True Range.” The default setting should be 14, which on the daily candles would be 14 days.

 

If you hate getting whipsawed (where the stock hits a lot of stop losses and quickly reverses direction, with you not on board), you can use options to hedge.

Below is an example of a whipsaw. Whipsaws tend to happen when the volume is lower, since a large amount of stop losses will trigger the price to plummet and recover quickly. If you used a stop loss here, your stock would have automatically been sold for a loss before it recovered. Although the dramatic whipsaws like the one below are unavoidable if you are using stop losses, you can do something about this if you are tired of getting whipsawed.

All you need to do is not use a stop loss.

But Nathan, didn’t you say that managing losses and making sure you don’t lose too much on any one trade is one of the most important parts of trading? The answer is yes, and with the power of options, you can manage risk without using stop losses.

Whipsaw example HTHT 3_17_2018.PNG

What you can do is to simply buy a put option. You buy the put option with a strike price where you would normally have placed your stop loss order. The maximum you can lose on this trade is now the premium for the put option plus the difference in purchase price of the stock and the strike price of the option. (Read or review my post “What are Options,” if your mind is still swirling from what I just said).

For example, if you bought 100 shares of AAPL at $180 and originally wanted a stop loss at $170, you can simply buy a put option with a strike price of $170 instead of having the stop loss. This is called a married put (easy to remember right?) The maximum you can lose is $10 per share times your 100 shares plus the premium you paid for the option, which lets say is $300 for a monthly put option. Your maximum loss would be $1300 in this case.

What’s nice about the married put is that even if the stock drops to $0 before your option expires, you still can only lose $1300. Let me explain.

Remember that the put option gives you the right to sell 100 shares at the strike price, which happens to be $170 in this case, before the contract expires. If you already own 100 shares, and the stock drops to $0, you can still sell those 100 shares that you own at $170.

One final thing that you can experiment with is having both a stop loss and a mental stop loss. The stop loss will be placed further away from the stock price, and the mental stop loss will be closer to the stock price.

Let’s use the AAPL example again. Say you decide to set a stop loss at $170, but you decide ahead of time that if AAPL drops below $175, you were wrong about the trade, and will sell AAPL for a loss. By using your mental stop loss at $175, you may be able to cut your losses even sooner.

On a final note, although everyone praises the famous saying, “cut your losses short, and let your winners run,” be sure that your losses are not cut TOO short.

What I mean is that if you place stop losses too close to the current stock price, you will constantly be stopped out of your trade with a small loss. If you never give your stock enough time or room to move in your predicted direction, you will experience a string of losses with no wins.