The Best Stop Loss for Long-Term Investors
There is always a chance that the stock will reverse direction just after it has triggered the stop loss, no matter where a stop loss is placed. We wanted to know if the amount of decline allowed by the stop loss affected the probability of a reversal immediately after the stock is sold. To answer this question, we computed the percentage of incidents (over a period of about 20 years) in which a drop of various specified magnitudes from a recent high was followed quickly by a resumed up-trend, rendering the sale unnecessary.
For example, we discovered that by changing an automatic stop-loss from 8% (below the high) to 9%, we could reduce by 50% the percentage of unnecessary sales at a loss. Further research revealed that after a drop of slightly over 14%, there was another dramatic drop in the number of "whipsaws." A drop of this size was significantly less likely to be recovered by the stock in the near future than for all drops of less magnitude. Therefore, a stop-loss of 15% does make a lot of sense. Sometimes, however, stocks do recover. There is absolutely no way for a person who uses stop-losses to avoid selling some stocks just before they resume an up-trend. Regardless of where the stop-loss is set, a post-sale recovery will sometimes happen. At any given moment, an individual can only know what IS (where the stock is at the time of the sale), not where it will be thirty minutes later.
When we decide to keep a declining stock, it is because evidence suggests it is the best thing to do under the circumstances at that moment, not a week later or even 5 minutes later. By definition, hindsight never exists in the present. Therefore, we will sometimes be wrong. If we keep the position and we are wrong, our loss might be 15% on that one position. However, we will probably be right more often than if all stocks are automatically sold under a stop-loss discipline that automatically sells on any decline of less than 15%. That does not mean a stock should always be given latitude to drop 15% before it is sold. The patterns of support and resistance (demand and supply) displayed on a chart of the stock are mitigating conditions. We have found that setting the stop-loss at about 15% for long-term investments generally works well as the maximum decline allowed, but many stocks should be sold long before that. For example, if there is obvious strong support 2% below the current price there is no need to set the stop loss at 15%. On the other hand, an investor could make it a rule that no stock is to be purchased if it is reasonable to set the stop loss any more than 15% below the purchase price.
We analyze support and resistance zones for each stock. When stockdisciplines.com traders buy, they buy with reference to a pre-determined stop-loss that is based on their analysis of supply (resistance) and demand (support) zones. They calculate the stop-loss before they buy, and they buy a stock only if a decline to the calculated stop-loss is tolerable in view of the gain expected. The market does not remember or care where anyone buys a stock. However, it does "remember" past regions of support and resistance. Technicians can see the shapes of these regions in the chart of a stock. Remember that a chart is simply a record of the effect of supply and demand forces on stock behavior. Price and volume movements do tell a story.
If a stock has very strong support 2% below its current price and it declines, breaking through that support, it is not likely to rebound soon, if at all. The same thing is true if a stock has built a good "base," is bought on a subsequent breakout through overhead resistance with a large increase in volume, and then it breaks down enough to trigger a stop loss set just below support. It is unlikely that we will regret the sale later. The conditions are defined sharply enough for us to render an accurate assessment of where the stock should be sold. Thus, it is not necessary to set the stop loss at 15%. Even if the maximum loss permitted is 15%, the average stop loss would likely be a much lower number. If your average is 8%, then some stop losses will be less than that. The greater flexibility available through support and resistance analysis will yield much better investment results than would be possible if a person rigidly sold all stocks when they were at a loss of 8%. Support and resistance analysis should enable the investor to avoid many "whipsaws" that could not be avoided with a more rigid system. In many cases there would be a profit where a more rigid system would have sold at a loss.
Changing the number of positions your portfolio is designed to carry could be a means of modifying the foregoing. For example, a twenty position portfolio could allow a stock to drop 20% without it inflicting more than 1% worth of damage on the portfolio. However, allowing more than a 15% decline did not produce any further improvements. In our view, therefore, there is little reason for most investors to expand the number of portfolio positions to more than 15 stocks. What we have said is based on the premise that the investor does not want to allow any position to be capable of damaging the portfolio more than 1% in a worst case scenario. If the investor wants the potential damage due to a single stock to be limited to no more than .5% and wants stop losses set at 15%, then the portfolio should contain 30 stocks.
Our research showed that allowing a 15% decline for the stop loss dramatically reduced the chances that the stock would turn around immediately after it is sold. This information can be a powerful tool that a long-term investor can use to shape his stop loss strategy for maximum effectiveness. It can be used to set the tolerance for the negative impact of any single stock on a portfolio at any level the investor desires. To keep that 15% drop from impacting the portfolio more than 1%, each position cannot represent more than one-fifteenth of the portfolio. From this perspective, then, a 15-position portfolio is optimum for a long-term investor.
All of the foregoing assumes that the investor prefers to use a straight percentage stop loss. He should not. A volatility-adjusted stop loss is far superior. It makes far more sense mathematically and statistically. By nature, volatility-adjusted stop losses are based on the probabilities associated with an individual stock's volatility. Straight percentages are arbitrary, but volatility measurements based on the action of the stock itself are not. That is the very reason why we have created tools that calculate volatility stop losses. Of course, placing a stop loss just below a recent relative low is the preferred placement. There is support there. If the stock falls through all the buying at that support level, a person has very good reason for selling immediately. Sometimes there is no recent relative low to use as a reference point. In such cases, a volatility based stop loss is next in the line of preference. Straight percentages are the least desirable and are completely unrelated to the dynamics of the stock.
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