In the late 1950s a Hungarian dancer called Nicolas Darvas spent 18 months making more than $2 million in the stockmarket. In less than a decade he’d gone from knowing nothing about investing to refining a trading style that stunned America’s financial elite. Early on he was forced to count the cost of poor advice, ill-timed trades and his own over-confidence. Yet those lessons shaped a strategy that combined investing rules, chart patterns and strict stop-losses, which eventually netted him a fortune.

Some years later, Darvas wrote a book called How I Made $2,000,000 in the Stock Market. In it he explained:

“I built a fortune with serenity by avoiding premature selling yet making an exodus from most of my stocks using a single tool: the trailing stop-loss... My stop-loss method had two effects. It got me out of the wrong stock and onto the right one. And it did it quickly.”

What is a stop-loss?

A stop-loss is a pre-arranged price at which an instruction is automatically issued to a broker to sell a share. It can be fixed at the time of the trade and, generally, any time afterwards. In regular, long-only investing the ‘stop’ will be set at a percentage level below the buy price (more on this shortly). Stops can also be used in short-selling by limiting losses if the shorted share actually rises in price.

Regular Fixed Stop-Losses are offered by brokers to help investors limit their exposure to a share that falls beyond what they are prepared to bear. Nicolas Darvas used a second type of stop known as a Trailing Stop-Loss, which moves in tandem with a rising share price (but doesn’t move down). This can be done manually but many brokers offer automatic trailing stops as well.

But care is needed - stop-losses aren’t always fool-proof. If markets swing overnight and open markedly lower than the previous day’s close, then the stop-loss may be missed. Equally, in low liquidity shares, where brokers may struggle to find buyers, the stop-loss price may not be guaranteed. For this reason some brokers offer ‘guaranteed’ stop-losses, but these come at extra cost.  

Why use a stop-loss?

Research into the use of stop-losses has found that they are useful in reducing investment risk and can actually improve returns. This is because they’re an antidote to something behavioural finance experts call the Disposition Effect. This is the technical term for the fact that private investors…

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