Stop losses - how and why you should cut your losses quickly

Friday, Oct 03 2014 by
13
Stop losses  how and why you should cut your losses quickly

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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As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested. ?>


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20 Comments on this Article show/hide all

cig 3rd Oct '14 1 of 20
3

Stop losses expose you to gap risk (limit orders hit on intra day book sweeps or other short term quickly reversed moves, or if manually executed the price moving well beyond the stop) that won't show up in most academic work that uses daily prices and assumes they are directly tradable. Depending on the extent of the problem, it can remove the entire theoretical advantage, or worse.

As for people like Darvas, there's the possibility they use stop losses as their favourite tool, but positioned them, consciously or not, using some information/ intuition/ chance that is not available to someone who just applies them mechanically.

Trailing stop losses applied systematically is a crude form of technical analysis (the only input of the sell decision being past prices) which is a mixed blessing at best.

if you're collecting testimonies, also calling for people whose stop losses caused a disaster would be only fair...

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kuronagi 5th Oct '14 2 of 20
5

If a stock I have researched and bought falls, I tend to buy more rather than sell. I call "stop-losses", "stop-profits".

But I am a retired (fundamental) equity analyst and regard technical "analysis" as useless "mumbo-jumbo". "Stop-losses" are encouraged on novice investors by spread-betting and derivatives companies where "investors" (punters) trade on margin. Market traders can take advantage buy pushing share prices to trigger stops.

In summary, forget about "stop-losses" if you are a serious investor!!!

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AlanJenkins2 5th Oct '14 3 of 20
2

I don't use stop losses,but if a stock that I own starts,to fall,I do try to find out why ! I will take a loss when I think that the stock is overvalued,just as I would take a profit. That can happen when the news is really bad and the stock is likely to fall further.

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GrindertraderUK 6th Oct '14 4 of 20
7

I use a stop loss in every single investment, following Robbie Burns advice of 10% starting point and then adjust a few % here and there to take into account volatility and support/resistance points.

I am one of the few PIs that have actually made money in COMS, QPP, GBO and a few other high risk speculative shares. The reason that I have consistently made money for the past few years is because I have been stopped out ! I then moved on while everyone else moaned on the bulletin boards on why the share prices dropped considerably all because of stop losses being hit.

For many months those who advise everyone against stop losses now sit in 50% plus losses on these companies while I move on!

Any stock that is high risk speculative I would say is crazy not to have a stop loss. Being stopped out forcing me to revaluate that certain position. It's gives me breathing space. A time to reflect on that particular trade and an added tool to remain unemotional.

Even my main portfolio of well researched growth stocks has a mandatory emergency stop loss in place because you just never know what will happen. The stop loss is a tool to combat my confirmation bias that I am wonderful, the best investor ever and nothing can possibly go wrong with this investment considering all the research that I have done.

I would also say that because I have been stopped out on a few companies (mainly the AIM ones) in my portfolio is that I now hold 40% cash while a few months ago I had 100% invested. I am protected from the AIM bear run and now my strongest stocks are either side lining or actually rising against the bear market.

However I no longer advise on the use of stop losses on the bulletin boards as I have been heavily insulted for doing so!  No wonder the majority of PIs underperform the market.

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rick 6th Oct '14 5 of 20
1

I use stop loses and trailing stops on most of my investments. They are generally kept wide and are not of a fixed percentage variety, the idea being to keep them out of the traffic of daily volatility. I do not put them directly into the market (order book) but check them on an end of day basis.

There are several advantages of using stops, but also several disadvantages (that I am sure many spreadbet users are aware of). Advantages include: stopping your personal emotions getting in the way of making money. Stopping you out of situations BEFORE bad news hits a share (and everyone wants out). Allowing you to back-test strategies and therefore test different approaches or investment styles in a quantitative fashion (we all overestimate our own abilities - I bet few people ever back-test their investment process).

Disadvantages include: being taken out of good positions on short term weakness (often by a point of two) only to see the price go back up (market makers know where all the stops are placed from their book - they often use them to fill big buy orders). They are generally weaker in illiquid investments like small cap shares which jump about and often gap up/down by sizable amounts i.e. they do not act as significant protection.

If you put stops into the market (which is the only sensible thing if you use leverage) via SB/CFDs your timing needs to be perfect, because they are easily hit and will be hit if at all possible by your broker or a large market player. It would be good to hear from a consistently successful SB/CFD trader who uses stops. Do they trade small/mid cap UK shares OR more liquid markets such as FX/commodities? How do they decide on their stop value?




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UK Value Investor 9th Oct '14 6 of 20
2

Just to offer the opposite viewpoint, I never use stop losses because I buy companies and don't really care how other investors value those companies, other than to buy when prices appear low and sell when prices appear high.

If I buy a company and the next day someone offers to buy it from me for 10% less than I'd bought it for the day before, why would I sell? Nothing has changed the long-term economic outlook of the company, at least most of the time.

Once I've bought a stock I effectively ignore its share price, unless of course it goes up a lot and I can sell to make a faster profit than I was otherwise expecting.

Blog: UK Value Investor
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jonnyt 9th Oct '14 7 of 20
1

So what if you got it wrong and watched the price plummet 50%, 60%, 70% or even 90%

There are plenty of shares that look good on value metrics that have done this and worse in the past.

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Edward Croft 10th Oct '14 8 of 20
3

There's a good quote from Peter Lynch on this subject on p244 of One up on Wall St.

If you can't convince yourself "when I'm down 25%, I'm  a buyer" and banish forever the fatal thought "when I'm down 25% I'm a seller" then you'll never make a decent profit in stocks.

Now he's a legend of course... but it's easier to talk like this when you are riding a 20 year bull market.  The last 15 years have been very different to the 20 years in which Lynch sealed his fame.

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roddy10 12th May '16 9 of 20

I know it has been a couple of years since this thread was active but let me add a few points:
1. How you trade has got to fit in with your personality, experience, time and nature of your portfolio. Whether one person uses a stop loss or not only matters to them.
2. However I would suggest that leveraged money often requires stop losses to ensure that one position going off does not lead to significant overall loss of equity.
3. In small caps a stock loss is often hard to execute - on a bad day the bid - offer spread (eg immediately after a profit warning) can be 5% or more - indeed it might not trade
4. The number of positions and their correlation in your portfolio matter. A highly correlated book of concentrated positions might be susceptible to move against you fast.
5. Time matters - if your full time job is portfolio management / looking after your investments you probably have time to go through each position each day. If you are busy with other things then a level is a good way of alerting you to review a position.
6. Position sizing matters - if your position sizing is on an allocation model / dollar averaging - ie I have £100 and I will split it into 40 positions and add £10 each month then a stop loss might be less of an issue. If however you position size according to 'risk' you might have 20 positions and are leveraged up from £100 10 fold to £1000 then you might want some automatic rules to get you out. A single position in this example could be £50 so a 20% move is 10% of your original equity.
7. The big issue with stop losses is often that they are too tight. Various books suggest using 2 standard deviations or 2 x ATR (average trading range) to set your level.
8. Personally I use two sets of 'levels' - a hard stop and a soft stop. The 'soft stop' is where I will review a position and consider if I need to get out or indeed add to a position. The hard stop covers me if I am out the office etc.
9. Some of my best long term investments have had lots of short term pain. However my soft stop has also sometimes made me review my research and realise that I missed a significant bear point.

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roddy10 12th May '16 10 of 20

Incidentally a long time ago (probably 20 yrs) since I read Nicolas Darvas' book but I recall he also used 'boxes' to define his trading. Never come across anyone else describe them that way. Often wondered how successful he was subsequently.

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herbie47 12th May '16 11 of 20

In reply to post #131225

From wikipedia: "At the age of 39, after accumulating his fortune and also being exposed in Time magazine,[6] Darvas documented his actions in the book, How I Made 2,000,000 in the Stock Market. The book describes his "Box System", which he used to buy and sell stocks.

1960 criminal investigation[edit]
Time magazine subsequently reported that the New York Attorney General had "thrown the book" at Darvas, charging that his story was "unqualifiedly false" and that it could find "ascertainable" profits of only $216,000.][8] The action was the first to be taken under a broadened state law that banned fraud or misrepresentation in giving investment advice.

In a follow up, dated 13 January 1961, Time reported that the probe was blocked by the court, which ruled that the investigation by Attorney General Louis J. Lefkowitz was an "unwarranted invasion of the free press". Time also reported that state investigators admitted that they had not been able to track down all of the dancer's brokerage accounts.[citation needed]

Darvas called the charges false, a "cynically irresponsible action, book burning by publicity".[9] He stated, "I keep out in a bear market and leave such exceptional stocks to those who don't mind risking their money against the market trend".[10]

Darvas claimed to have never sold short. He said in 1977, "I have never done it myself because psychologically I am not cut out for short selling. But I think markets have now changed their character so much that all experienced investors should seriously consider it. It is not for the proverbial widows and orphans, though." [11]

The Anatomy of Success[edit]
In his third book, he wrote "Later, I went on to explore and become successful in other fields, the fashion industry, theatrical producing, real estate are just a few". Here he claims "the formula for success remains essentially the same". In the book he set out what he called "the rules to be followed".[12] "But one must know the correct route".[13] In his last book, You Can Still Make It In the Market,.[14] Darvas gives the rules for a method called "Dar-Card"."

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herbie47 12th May '16 12 of 20

In reply to post #86901

So what do you do if there is a profit warning?

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UK Value Investor 13th May '16 13 of 20

In reply to post #131231

Having read my original comment again (after a couple of years!) I should point out that I try to invest in good, mature, market-leading, fairly large, etc. companies, so that's the context for my lack of using stop losses. I don't expect the companies to go kaput and so am not worried about share price declines in and of themselves.

As for profit warnings, if it's purely a profit warning then I don't do anything other than read the announcement. I try to think about where the company will be in five years rather than what will be happening this month or next, and on that longer time scale a profit warning today is mostly irrelevant.

Hopefully by investing in 'good' companies and profit warning and decline in fortunes will be reversed in the years ahead, although of course it won't always be. But as long as things turn out well much more frequently than they don't, then I'm happy to keep doing nothing when profit warnings appear.

Blog: UK Value Investor
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herbie47 13th May '16 14 of 20

In reply to post #131267

I see, yes I don't have stop losses on FT100 shares although maybe I should have on Next (LON:NXT). But even well established companies can have problems, one I missed recently due to a stop loss was Interserve (LON:IRV). I admit stop losses have been a mixed blessing for me, saved me on several occasions from bigger losses such as Lakehouse (LON:LAKE), Sprue Aegis (LON:SPRP) and Sepura (LON:SEPU), Entu (UK) (LON:ENTU) I got out before the crash.Generally I like to sell after a rise or before a stop loss happens but sometimes there is no warning. Certainly on new companies I would have a stop loss around 15% below my buying price. Profit warnings often come in 3s.

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roddy10 13th May '16 15 of 20
2

In reply to post #131267

I like your website and approach so hopefully this will not sound too harsh.

One of the big bugbears I have is people saying that they invest in 'good' companies. The issue for me is whether 'good' is defined post hoc or ante hoc. Generally I find that people say a company is 'good' because it has gone up rather than any tangible objective measures. Now given we are all on the Stockopedia website I would suggest a high value rank and a high quality rank are actually a sign of a 'good' company.

I once worked in an institution where virtually every fund was an investor in Tesco because it was a 'good' company - they were also investors in many of the mining stocks. But when you drilled down and dug you found that actually they all thought the companies were 'good' because they had gone up a lot. Needless to say I did not win friends by trying to short the biggest positions of my colleagues....:-)

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Paul Scott 13th May '16 16 of 20
10

Stop losses are for traders (and work well for them). They are not for investors.

Many people think they are investors, but are actually traders.

Different strategies work differently for different people. Just keep doing more of whatever works for you.

For me, the original price I bought at is completely irrelevant. The stock is either a good investment now, or not. It doesn't matter what I originally paid. That has no bearing on my decision on whether to sell, or buy more. It all should be based on a fresh analysis of the stock as of today. That's all that matters. Anything else is just emotional background noise.

Regards, Paul.

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roddy10 13th May '16 17 of 20
1

In reply to post #131393

Paul:

1. You have highlighted a key point in your comments - your trading / investing process needs to suit your personality.

2. Secondly even wearing an 'investor' hat (and I appreciate that these 'hats' come in various shapes and sizes) I find a 'soft' stop invaluable as a discipline to re-review my hypothesis (you term this 'fresh analysis').

3. 'Emotional background noise' - indeed - but the way to filter that out is by having a process. The process might be as simple as '(a) I will review all company announcements (b) if the stock falls 10% on a day I will check if there is any news I have missed and also dispassionately undertake a new analysis (fresh, repeat, renewed or any flavour you wish) of my hypothesis - if new information comes to light which leads to significant questions on my hypothesis I will close; if the questions are substantive but not significant I will investigate further (eg ring the company); if my original hypothesis is reinforced I will buy more subject to my portfolio limits'.

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Paul Scott 13th May '16 18 of 20
2

In reply to post #131399

Hi Roddy,

Great points, I agree with all of that.

I reckon automatic stop losses are a good thing for;

1) Novice investors who are really just gambling,

2) Story stocks, for people who get sucked into rubbish AIM jam tomorrow stocks & do no proper research,

3) People who are too busy to properly monitor their positions.

Apart from that, there's no substitute for proper research.

My best investments have nearly all come from where I've done more & more research, and taken account for poor market sentiment, to load up to the hilt with a fundamentally great stock at a bargain price. But I would never suggest that approach to anyone else, unless they really know what they're doing. Even then we all get caught out by unknown events.

Regards, Paul.

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UK Value Investor 14th May '16 19 of 20
1

In reply to post #131390

I think you're right. Most people do equate 'good' with 'going up'. I can remember back in the early 2000s when I was a fund investor looking at the 1yr returns of funds to see which ones were 'the best'.

That's okay if you're a momentum trader, but if you're primarily an investor its nuts.

My definition of 'good' covers a whole slew of factors covering growth, profitability, capital intensity, debt, acquisition record and more, and certainly isn't based on whether the shares are going up. In fact as a value investor I'm mostly buying stocks that have fallen in value.

Having said that, 'good' is a pretty vague definition of a company. The general idea is that the intrinsic or net present value of the company should be going up rather than down, but there are a million different ways of thinking about that because nobody nobody knows the real answer as they both depend on future corporate performance.

As for Tesco, I still think it's a 'good' company, perhaps the best supermarket in the UK and possibly the world. But it has seen a major shift in its market which could take a long time to adapt to. Also, the old management did make the mistake of having too much debt, not closing their defined benefit pension scheme soon enough and not taking the discounters seriously. But good companies can make mistakes without undermining their basic 'goodness'.

Blog: UK Value Investor
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herbie47 14th May '16 20 of 20

In reply to post #131426

I think you are right about companies, its often where you get in or out, the company is the same, a bit like a bus ride, its the same bus but the road goes up and down. I touched on this in the post about stop losses I think, about winners and losers, really its about the future, how a company will do, even if a share has gone up 100% it can still fall. really you still need to review winners, quite a few of my winners have fallen recently, although I did sell quite a few. I don't agree really about Tescos but then I have never liked Tescos as a shopper, I prefered Sainsburys and Aldi, I don't think Tesco has been well managed for the last 5 years or so, why do you think its the best? It has new management now so maybe they will turn it around. I regard Next (LON:NXT) as a good company even though the share price has fallen nearly 40%.

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