Initial Technical Stop

30th Nov '17 by matylda

20 comments 6323 reads

Just throwing this out there for comment really as I was just giving this some more thought today (based on what I kind of usually do) and am just about to finish for the day.

Note - I am the kind of person that likes to take a 20% loss max on any share - I know some like to hold and add if the picture hasn't changed but me, I just think I've got it wrong and get out - The old, you lose 20% on this, you only need 25% on that to make up for it.

I'm not even sure if this is a valid starting point for many but it's one that kind of makes sense to me and is kind of in-line with what I do now (most of the time!!!).

STOP 1 (CONSERVATIVE)

A 5% + Spread Stop below the low of the last 12 months?

The thought being - Just about to invest in something that will perform better than it did in the last 12 months.

So, if it breaches the low made in the last 12 months (by 5% + Spread) it could be considered Mr. Market does not agree.

STOP 2 (AGGRESSIVE)

A 5% + Spread Stop below the low made since the significant high made before the current significant high. This one's not so easy but say we rise to 200, then make a low of 180 and then rise to 220, this would mean a Stop at 171 (180 - 9, assuming no Spread).

The thought being - Just about to invest in something that will perform better than it did in the last 12 months AND in-line or better than my interpretation of the most recent fundamentals.

Sometimes it's really hard to put this stuff into words.

Anyway it's an attempt to put my own approach (used most of the time), into words.

And, maybe prompt some discussion on a subject which is I believe is dear to the hearts of many. And, perhaps, change my view/approach to Stops.

As an aside....

This is actually how I usually calculate my Entry - I usually first work out my Stop based on the above - Add 25% to the Stop and that's my Entry. So, if I take that Entry (when it's 25% above my Stop) I know I…

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PhilHofGrowYourDough

30th Nov '17

Stop losses and initial stop losses will depend a lot on your buying style.
For example I buy stocks that break out, so I can set an aggressive stop (although I use notional stop losses that I monitor daily) at most being 10%.

If you're LTBH you might never use a stop, in fact you might average down.

matylda

1st Dec '17

Thanks for the comment Phil, I totally agree, "initial stop losses will depend a lot on your buying style".

Mine is to ensure I never lose more than 20% of any investment - I have an absolute cut off at 25%. As many are aware, assuming equal position sizes (which I also try and ensure) a 20% loss on one requires a 25% upside on another, a 25% loss requiring a 33% return.

I never average down, except when I break my rules of course. This is something I rarely do but when I do, I frequently regret it. At the very least it makes me break my rules less!

Breakout

Personally I don’t bother with stops, for two reasons :

1 Just giving your hand away to the market makers
2 Asking to be shaken out by the lovely market markers

My advice is just keep a close eye on your portfolio sell anything that drops to 7-8% below what you paid for it...oh it’s sounds so simple now I’ve written it down

Minervini would ask you

"What is your percentage of winners and losers?"

&

"What is your average gain for your winners?"

as a generous stop loss of 20% might well mean that you have to make big gains on your winners in order to make a profit.

Best of luck
Phil

Re: Bother with stops, all are mental and I never use orders, unless I am in a Spread bet (not often).

Agreed Phil and as someone looking to invest for a long time-frame, 5 years+ my strategy is typically to sell half when it doubles and then leave the rest of it as a "markets money investment".

Thanks all for the input, most welcome.

cig

Imagine someone sends you their portfolio (current positions only, without the history) and asks your opinion on what to sell and what to keep. Presumably you will tell them to sell stocks you think have poor prospects going forward. What if you happen to have one such stock in your portfolio? Sell or hold?

Nick Ray

A couple of observations...

Firstly have a look at the histograms in this article about drawdowns. You will see that even good stocks will have drawdowns of over 20% in a 1-year time frame. So being too aggressive with stops is not necessarily a good idea unless you are trading with holding times in the days or weeks. The very best stocks in a given year will have gains well over +100%, so is -20% really worth worrying about?

Secondly, the idea that after a -20% fall you need to work "harder" because it is now +25% to get back to where you were is not quite the whole story. If a stock were to fall by -20% and then rise by the same +20% repeatedly it would indeed drift slowly lower. But we can measure that by simply computing the "drift" explicitly. Because of volatility we need to use at least a year's worth of price action to get a decent estimate of drift (i.e. mean return). All the excursions above and below that are then "volatility". When dealing with randomness of multiplicative processes we need to work with log(price) and ultimately that is why -20% and +25% are equal distances away from the mean. [Essentially: log("-20%") = log(0.8) = -log(1.25) = -log("+25%")]

If you were to rebalance the stock back after every rise or fall you would extract a small gain over and above the drift of the stock. This is "volatility harvesting" or the "rebalancing bonus" and it is about 0.5*σ^2 (where σ is the volatility).

On the other hand if you sell when the stock makes a negative excursion (i.e. you use a stop-loss) you will lock in a negative bias in your trading. The easiest way to counteract this negative bias is to instead buy or sell on a fixed period basis where the period is long enough for the drift to dominate the volatility. So for example, every six months you would review all stocks in your portfolio and sell those that have performed the worst over the last six months.

Rusty2

But is that the right thing to do, I used to do similar but looking at my portfolio, I would have been better off holding or averaging up the winners, if I had sold half of my best performing shares I would have lost quite a bit. At 100% profit, sell half, if it 10 bags then you have lost 4 bags. I quite like Leon Boros idea of letting your winners becoming a large proportion of your portfolio as they grow and your losers shrink.

Also stop losses may not save you from having over 20% loss, as they are not guaranteed, if the price falls say 14% then the company issues a bad profit warning the shares will fall, maybe 30-40%, I had on Lakehouse (LON:LAKE). In an event such as Brexit, then you could lose control of you shares, this happened to me with Next (LON:NXT).

ISAallowance

Well, yes and no. I only have Minervini's first book, but I don't think the stop-loss example he gives tells the full story in all circumstances.

If you have 1 position, and keep rolling it over to the next one, then 5 20% losses and 5 25% gains will result in break-even at the end of the year, accepted. But if you instead have 10 equal sized positions, with again 5 20% losses and 5 25% gains, then your portfolio is up 2.5% at the end of the period.

Likewise in Minervini's example near the end of the first book where he has 10 18.4% gains and 10 15.9% losses giving a 12.05% loss, this would be an overall portfolio gain if done as 20 equal sized positions. Additionally, he admits that "capping the losses would have knocked me out of a few of my winners" but completely ignores that in the worked example!

What he says is valid for a concentrated portfolio where each trade is compounded to the next. It's not quite as applicable to a more diversified portfolio with longer holding times for running winners IMO. As Herbie points out above, if you run winners long enough they eventually come to dominate the losers. I guess the ultimate expression of this would be David Gardener, who basically stated that he never sells anything.

Here's an extract from his latest book ...

Thanks Phil. That makes much more sense to me than the example from his first book.

2nd Dec '17

50*10 / 50*5 = 2:1
40*15 / 60*5 = 2:1

Shouldn't those calculations be:

(50*10 - 50*5)/100 = 2.5% "expected" return per turn

(40*15 - 60*5)/100 = 3% "expected" return per turn

In other words the second situation is preferable to the first situation.

I think he's looking at it like a gambler would ...

Winnings = 50 * £10 = £500
Losses = 50 * £5 = £250
I win £2 for every £1

Winnings = 40 * £15 = £600
Losses = 60 * £5 = £300
I win £2 for every £1

But ... I have the increased pressure of having to improve my winners by 50% on scenario 1

I think what he's trying to help readers understand is that there a few elements which we can try to control when investing:

Average gain
Average loss
Batting Average

He's highlighting that if we have a poor batting average then it's more important than ever to manage your losses as you only option then is to try to win big ... which brings its own problems.

Not sure if that helps?
Phil

aflash

3rd Dec '17

All I can add to the excellent comments here is that ostensibly you are dealing with small caps which means low liquidity plus spreads of 5% or more.
That means:
1) stop losses may not be triggered at your price but lower, when a buyer appears.
2) it may just be a time when there is not much stock market interest although the company may be doing fine.

Had discussion been invited on large and liquid stocks I would reply it is an interesting approach but more a trading than fundamental one.
If it is a trading one then Technical Analysis is relevant and I ask 'why restrict yourself to 12 Months?'
It could be a year when general Investor Psychology was timid and the stock of a perfectly good company be oversold.
I look at 5 and 10 year patterns but that is another story.

Minervini not only presents the money management techniques referenced here but also looks at lots of charts. He has agressive stop loss techniques but on fast movers.

Maybe your method could be refined according to general market conditions, average volume for the issue and at least the slope of the chart. Then, of course, it would cease to be an Automatic Rule than overules Emotion which is apparently what you want in place.

Minervini has said in a Webinair that he often never lets a loss get beyond 7%.

I should add that it is not 3 a.m. here in Baja California.

Minervini says touch your nose!

Usually the risk:reward ratio is defined as W/L. Then if p is the win probability (what Minervini calls the "batting average") you need W/L > (1-p)/p which is mathematically the same as asking that the "expected" (i.e. mean) return is greater than zero, i.e.: p*W - (1-p)*L > 0

However Minervini in that book extract seems to have combined the two ways to look at it and defines the risk:reward ratio as p*W:(1-p)*L and then asks for that to be better than 2:1.

That is definitely unconventional. But it would be equivalent to the conventional approach if he required that his version of the ratio was better than 1:1.

There is a dangerous trap for the unwary lurking even with the conventional use of risk:reward however. As you increase the W/L ratio the probability of a win will reduce. If you choose a particular win:lose ratio you had better have the data to know what your win probability will really be or you are still shooting in the dark.

What usually happens is that p*W - (1-p)*L turns out to be approximately equal to the return for the (subset of the) index you are choosing your stocks from. When you make that realisation you begin to understand that it is not the trading in and out of the stocks which affects your returns - it is the choice of "good" stocks (essentially factor investing) which does all the work.

Smudger

10th Dec '17

I am new to Stockopedia but have been tending a stock portfolio since 2008 after I moved from mutual funds to stocks. I concentrate on dividend growth and signed up so that I can quickly spot dogs in my portfolio. So far I have found about 4% dogs, but will use Stocko continually to keep weeding. I do NOT use stop losses. I have been hurt by them. I have abandoned all attempts at "technical analysis" (chart voodoo) to try and set them. I just hold high-quality dividend stocks as the core folio. When the price drops, which it always does, any auto reinvested dividend "buys" more shares. Now, assuming the overall trend is up, then these inevitable drops will amplify compounding and accumulation. Using the drops to create an advantage! When I discovered this effect I also abandoned bonds since I don't need more than dividends to live on.
Conversely, when prices get bubbly (i.e. Stocko Value ranks drop), I switch off automatic dividend investment and use the pooled cash to buy some speculative nano-caps. But no more than 2% of my portfolio. I happen to concentrate on 2017 biotech recent POs issued in the USA (I buy after the IPO since I am a just one of the little guys). Stop losses would be ridiculous. A small volume transaction "when no one is looking" could easily cause a huge loss for a few hours when only say 50k shares are traded in a day. I estimate ~40% of these biotech nano caps will do very well (>10 baggers) but will fluctuate wildly. When prices return to a more sensible level I will be back to simple dividend reinvestment in the dividend growth core.

TangoDoc

11th Dec '17

All my biggest mistakes in investing have been in trading far too often. I have "lost" more by selling stocks that I guessed could not rise much more and then did. (National Grid) The next big loss, this time a real one, was selling a stock that I had faith in but used a stop loss when the rest of the world fell out of love. (Electrocomponents) I should have backed my own judgement.
By nature, I am no gambler. I have no talent for it, nor for timing my entry and exit from markets. However saddening it is to realise we small investors are the last to know real information, pretending otherwise never made me any money. Furthermore, we are the cash cows so needed by the investment industry. I also believe that every gain made by one investor is paid for by another one's loss.
This acceptance of my own philosophy and level of competence means that I have settled down to comfortable strategy that makes enough money to live on, safely in an ISA, and allows me to sleep soundly. I am an "orchardist". Year on year, I increase my acreage of fruit trees (shares), all of which must give me at least 4% dividend on my original outlay. Only when a particular tree fails to crop at that level, do I plan to chop it down. I look at arbitrary numbers for stop losses that frequent gamblers are obliged to use and am so pleased I am free from such impossible decisions. Before anyone comments that my chosen strategy cannot result in maximal wealth, my response would be that optimal is the ideal.

Initial Technical Stop

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Matylda

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