Financial Stop Losses – Part 3

In this, my final posting on this topic, I respond to Victor’s comment posted in response to my 28 May Blog. At first glance this blog may appear complex but the area of risk management and money management is an extremely important area of active investing so persevere to understand it well. Hopefully Blog readers will get a better understanding why generic money management methods don’t necessarily work at a practical level for all types of stocks/instruments unless they are tailored to your requirements.

“Hi Gary

My understanding of how stops should be set is this:

The placement of the initial stop SHOULD BE DETERMINED BY THE BEHAVIOUR OF THE STOCK. i.e. at a line of support (need to eyeball the chart), at an ATR multiple away from the entry, on a moving average etc.

The gap between the stop and the entry then DETERMINES THE POSITION SIZE. ie the max dollar risk per trade (be it 1%, 2% of portfolio value) is divided by the gap to give the number of shares for that position. This way more volatile stocks, with larger gap between entry & stop, will end up with lower position size ( in dollar terms), and low volatility stocks with small gap will have a larger position sizes ( in dollar terms).

This is similar to spa’s low med high entry risk system.

Whether it is any better than spa over the long term I have no idea because I haven,t done 10,000 hours of research because I am not 500 years old. But If I do use stops, the above method is how I go about it. ”

This is one of the most popularly written about methods of position sizing and risk management. It is far better using this method than using nothing at all or using a simple 10% per position in a portfolio. This is so because it is based on determining a technical exit position as determined by price action in the market and then working backwards to determine a position size which is interlinked with the technical exit rather than treating all stocks the same. Either the maximum dollar loss or the technical exit will ensure that the trade is exited, provided the active investor follows their rules and executes the exit.

As Victor states, the active investor will need to determine how the technical exit is determined. May I suggest that a consistent and objective method is used (rather than eyeballing) that you know works for the timeframe in which you wish to trade. To know it works you might need to do some backtesting. Hey, that sounds like determining a mechanical technical exit!!

However, the method suggested by Victor can have some problems that need to be highlighted and solved by the trader:

1. The choice of support level can be subjective and will be different depending on the trading horizon (short, medium or long term) and the technical analysis skill of the active investor. The moment subjectivity comes into the equation there is potential to change the criteria mid-trade, which is NOT a good thing, or to get it wrong by taking too much or too little risk on a consistent basis.

2. Using volatility based position sizing, i.e. “an ATR multiple away from the entry”, really only works practically for a small number of stocks on the market because nearly all the position sizes derived from this method would exceed the maximum of 20% of portfolio value that you should place in a single trade for any given portfolio. It really only works for highly volatile stocks with sufficient liquidity. Even then, what ATR multiple do you use? Traders trying to use this method usually solve this problem by adjusting the ATR multiple for different stocks which defeats the object of the method because the idea behind it is to allow the varying volatility (measured by ATR) to automatically adjust the distance to the stop level.

Let’s look at a couple of examples. To make the arithmetic easy to follow let’s assume a $100,000 portfolio and 2% max risked per trade, or $2,000, and exclude brokerage. Also, let me state another very important money management rule which is widely used to limit risk of portfolio ruin. This is the maximum position size for a portfolio and is set at 20% of portfolio value. Some may raise this to 25% which I believe is too high.

Example 1
Take a stock that has an ATR (15) of 46.5c and is priced at $23.20. The ATR of 46.5c as a percentage of stock price is around 2% which is where most large cap stocks will trade for months, or even years, on end, especially in bull markets, making this a very representative example.

2xATR ($0.93) to 3xATR ($1.395) are the most spoken and written about levels of setting a volatility technical stop loss which would be $22.27 and $21.80, respectively, in our example.

At first glance this looks quite OK. Now let’s calculate the position size using the most discussed and written about ‘2% rule’. $2,000 / 0.93 = 2150 shares * $23.20 = $49, 880. Oops, 50% of portfolio value and way too big! Ok, let’s try 3xATR. $2,000 / $1.395 = 1434 shares * $23.20 = $33,268.80. Still too big!! In fact to get a position size that is below the maximum position size of 20% of portfolio value you would need to use 5xATR and that would be just below 20% of portfolio value so you really would need to use at least 6xATR to get a small enough position size to allow for some growth in the position. 6xATR is $2.79 or 12% below the entry price.

To get a more realistic position size for stocks of around 2% volatility you might consider using the 1% max risked per trade just to get a position size that isn’t too big. This would allow a realistic position size down to 2.75xATR.

So where was the support and resistance technical exit for this example? A reasonable medium term support and resistance technical exit for this example based on a recent weekly low would have been $21.70 or $1.50 below the entry price. Let’s try this with the 2% rule. $2,000 / $1.50 = 1333 shares * $23.20 = $30,933. Too big. So we’ll have to use the 1.1% rule for this one to get a position size of around $17,000 which would allow room for a 17% profit before the open position approaches the 20% of portfolio value level.

Hopefully you can see that the single biggest determination of the final choice is what a reasonable position size is relative to the maximum position size allowable for the portfolio.

Example 2
For the second example let’s look at a more volatile stock such as Extract (EXT). The SPA3 entry signal occurred on 24/12/09 at $1.26 and the ATR (15) was 6.3c, or 5% volatility, which is relatively high. The short term and medium term support and resistance levels would be at $1.10 and $1.00, respectively. These is my subjective ‘eyeball’ opinion and is, hence, very debatable.

Let’s do the arithmetic. 2xATR $2,000 / $0.126 = 15870 shares *$1.26 = $19,996. This is too large so 2.5xATR with a position size of $16,000 would work better allowing headroom for growth of a high volatility stock. However, 16% of portfolio value is too big for my liking for a stock with these characteristics and would be a far larger position size than SPA3 would allow so you would probably need to use a 3xATR, 3.5xATR or 4xATR.

There are another two important considerations that these position sizing and risk management techniques don’t take into account:

1. Liquidity Risk. What if the position size is too big for the traded value that a stock is actually trading? For example, the calculations above provide a position size of $15,000 but the stock only averages $70,000 traded value per day on average. A trader’s rules must account for these too.

2. Market Risk. Position sizes should not be the same size in falling markets as they are in rising markets. To adjust for market risk is the ATR multiple changed and / or is the max risked per trade adjusted? What technical criteria are used to determine a rising and a falling market to determine when the position sizing calculation changes?

Conclusion for the last 3 week’s Blog postings
So what % rule for max risked per trade do you use and what technical exit rule do you use with which stocks and in different market conditions? Is it based on the percentage volatility of the stock, support & resistance or other technical patterns or indicators? I suggest that at the practical level the method discussed in this Blog is not as simple as the two or three pages that most books devote to the topic merely pointing out the formulae. I’m not saying that it is wrong, just that there are many more complexities to the method than most discuss or implement.

Financial Stop Losses and associated position sizing was one of the most debated sections of the course material amongst attendees in the SPA3 Training Classes that we used to run in the early 2000’s. Many years on it seems that nothing has changed!!

When you have a mechanical trading system, working out the risk management and money management is a far simpler exercise because you know the boundaries of the raw edge. All three components are intertwined and the existence of a mechanical exit system is the biggest simplifier.

Every system needs it own risk and money management that is tailored to the system depending on the objectives of the system, the time frame for the hold period of trades, the instruments that are traded and the risk profile of the trader that trades the system. Because this is tough stuff to work out traders gravitate to generic methods and accept them as the only truth without investigating the detailed practicalities of the method. I have no problem with not re-inventing the wheel but the boundaries must be determined of the exit and position sizing regime that is used and the generic method should be tailored according to the objectives of the trader and the trader’s system. And most of all, the money management and risk management system should work at the practical level, not just the theoretical level.