As traders and DIY investors we are tasked with skilling ourselves in an environment that is full of known and un-known variables. To help prevent the unknown variables from continuing to take capital from our portfolios, it is necessary to implement a strategy that exits trades based on either a technical exit signal or a financial stop loss.
Setting a financial stop loss is a Risk Management action as it provides an exit strategy for the active investor. Financial Stop Losses are generic Risk Management techniques and are NOT employed by SPA3 because SPA3 uses technical exit signals. Financial stop losses are explained here to put SPA3 Risk Management and technical exit signals into context.
There are four types of stop loss that can be set:
• Initial Stop Loss (ISL) is the price at which the trade will be exited if the trade immediately goes in the opposite direction to what the trader’s analysis showed.
• Breakeven Stop Loss (BSL) is the price at which the trade can be exited if the trade starts off profitably and then turns in the opposite direction.
• Trailing Stop Loss (TSL) is a profit protection technique that is calculated as the price moves in the direction shown by the trader’s analysis. It is used to lock in profits when the price undergoes a reversal from the profitable position.
• Technical Stop Loss is an exit signal that is based on price action, a pattern or a technical indicator.
It is also possible to set profit stops which take profits into a trend but these are not discussed in the blog posting.
The ISL and BSL are set before taking a position in the market. The TSL is calculated (and re-calculated) while a position is still open. All three of these Stop Losses are defined as Financial Stop Losses as the exit price is calculated purely from the financial constraints that the active investor imposes on their open position. These are not related in any way to the market price action of the stock.
There are a number of well-known methods that can be used to calculate the actual stop loss:
• The most well known Stop Loss rules are the 1%, 2% or 5% rules, based on the total value of the portfolio. Which % is used should largely be determined by the term of the investment and risk profile of the investor. A short-term trader could opt for a 1% rule whilst a 5% rule would be suicidal for the short-term trader, whilst a 1% rule for the medium to long-term active investor could prove a bit restrictive.
The 2% rule will be used in the examples to illustrate the generic use of Financial Stop Losses. This does not mean that 2% works best for medium-term active investment. In fact, therein lies one of the major problems of Financial Stop Loss calculation; stocks have different characteristics and move in different ways in the short and medium and long term. Applying a specific % Stop Loss rule across the board for all stocks can be too sweeping and is NOT linked to the behavior of a particular stock price in any way.
Furthermore, it is unknown how a standard % per trade would relate to overall portfolio drawdown for a particular methodology unless research is conducted.
For the purpose of illustration, a portfolio capital of $50,000 is used. This means that a maximum of $1,000 (i.e. 2% of $50,000) will be risked on any trade, that is, the maximum amount of capital that can be lost in any single trade is $1,000, including brokerage.
The ISL and the TSL are calculated using the 2% rule. (The position size can also be calculated using the 2% rule but that is a money management technique which reverses the calculation but also requires the trader in pick a price stop level.)
Assume that an entry signal occurs for a stockpriced at $5.50 and that $7,500 of the total portfolio capital will be committed to the trade. 1359 shares are purchased for $7,475.50 and brokerage of $25 is paid, for a total cost of $7,499.50 ($7475 / $5.50, rounded down)
In order to limit risk at $1000 of total trading capital, the ISL is set at $4.78 ($7,474.50) – $1,000 + $25 divided by 1359, assuming exit brokerage of $25).
The BSL is calculated by adding the buy and sell brokerage onto the $7,500, i.e. $7,550 and dividing by the number of shares purchased. The BSL is, therefore, $5.56.
The TSL will only come into play when the trade is in profit territory. Assume that the share price rises to $7.00. Assets on hand are now $9,513. The TSL would be calculated as $6.29 ($9513 – $1,000 + $25 = $8,538 divided by 1359). If this price is reached the stock is sold. A portfolio manager would dynamically recalculate the 2% and TSL on a daily basis.
• Another method often used for Stop Loss calculation is deciding a percentage of the trade capital to be risked for an individual trade. For example, if the capital committed to a particular trade is $10,000 then the ISL could be $1,000, i.e. 10% of the trade capital. The actual ISL exit price would equate to the $1000. Usually, a range of 5% – 10% is used with this method for medium-term active investment depending on the amount of capital committed to the trade.
The problem associated with this method of Stop Loss calculation for medium-term trading of equities is the same as the 1%, 2% and 5% rules for ISL, BSL and TSL – it is not linked to the market price action of the particular characteristics of individual stocks.
By setting these Stop Losses it is known in advance when to exit the trade. Psychologically, this is very important as it assists in making the exit more clinical otherwise it will leave the trader open to influence from emotions, ego and outside ’noise’. The size of loss trades will be consistent and largest loss trades, which are portfolio killers, can be avoided.
However, the major problem with Financial Stop Losses is that investors can get stopped out of the trade whose trend is still up, hence registering lots of small loss trades instead of a profitable trades. This results from the following:
• Financial Stop Losses do not recognise that all shares do not behave in the same way. Having a fixed trailing stop loss regime for all shares will, in many cases, stop profits by stopping the investor out of the trade before the trend has ended or even started.
• Financial Stop Losses are based on the individual investor’s financial constraints, not on market price action.
Financial Stop Loss settings, therefore, can counteract the whole basis of successful active investment: “Cut your losses and let your profits run”, which is all about following trends. If you exit the trend before it has ended, or even started, based on a financial stop loss, a lot of big profit trades will be missed.
SPA3 only uses technical exit signals (unambiguous and mechanical) based on market price action through the use of volatility based exits and momentum indicator exits. Over a large sample of trades, the average loss per trade is around 1% of portfolio value. This is not a targeted risk per trade percentage by design, merely an outcome of the SPA3 entry and exit mechanisms interacting with market price action.