Stop Losses the Right Way, Where, and How
When volatility is high and stocks are whipsawing up and down, how do you know where to place a stop loss? Is there a right distance from the stock’s price to place the stop loss? Is there a correct procedure to follow when determining where to put it? As the stock approaches the stop loss, you may get nervous and want to cancel the stop loss so the stock will not be sold. How do you keep from getting "psyched" out of a good stop loss and staying with a bad position too long (as when emotions cause a person to second-guess reason and remove the stop loss)? The answer to the first questions is related to the answer to the last question. If your stop loss placement is mathematically sound and based on the laws of probability, and you truly understand and accept what that means, you won’t be as easily psyched out. That is one of the advantages of a volatility-based stop loss. It is based on mathematically determined "significance." The same can be said for stop losses based on support levels. A breakdown through a support level is an event of significance..
Getting "psyched out" is a psychological problem that often gets in the way of disciplined investing. Once, when I was managing accounts on behalf of our advisory firm, a client called and asked if it wouldn't be a good idea to have stop-losses in place to protect us if any of our stocks plunged. I had just taken the positions and had not yet placed the stops. At the time, I agreed that stop-losses would be appropriate. I had been teaching clients for many months through Strategy Updates about the need to implement a stop loss for every position. The lessons apparently were sinking in. However, when one of those stop losses was triggered, a client called who wanted to know why I sold when the stock was still low. This person wanted to wait for the stock to be profitable before selling. However, my experience with such investors is that they would not actually sell if the stock did go up because they would think that the stock is doing well again (and, of course, they would argue that it would be silly to sell when the stock is doing well). The root of the stop-loss "problem" for most people is the uncertainty that stems from the lack of knowledge regarding proper stop loss placement. They either place the stop too far away from the stock or they place it so close that it is virtually certain to be triggered. Even if the stop loss is placed correctly, they make the mistake of judging its correctness by hindsight. Special Bulletin: A person who does not use stops is asking to be taught a lesson in risk control. The market will oblige.
If the second caller above had waited a little longer and had seen the stock continue to fall, he would have said it was good to have sold and that the timing was perfect. The point is that at any given moment one can never be 100% sure what a stock will do next. People often act as if they know that the future will be good to their stock (so they don't use a stop loss or they place it too far away). However, we live in the present, not in the future and most untrained people are uncertain and conflicted about the best place to enter the sell order. People are optimistic about the prospects of a stock when they buy it. Therefore they do not want to sell. They want to believe that they made a good decision when they bought the stock. They will therefore tend to set their stop-loss so that it is unlikely to be triggered. If a person sets the sell order low enough that it will be triggered only if a large downturn occurs, the stock may be sold after a decline of 20% or more. The key word for good stop loss placement is "significant." Placing the stop so that only a significant decline will trigger it is a good idea, but what does "significant" mean?If a stock repeatedly rebounds after a decline to $50, then there is support at $50. That means there is demand at that level. If the stock drops through that price, it means the selling was severe enough that it overwhelmed all the buyers at that level. That is a significant event. Just below that buying support is where a stop loss belongs. If the stock breaks through that support, it is destined to go lower. Stockdisciplines.com traders look for significant events like this, but they also look for events that are statistically significant. That is, when stock behavior is outside the normal distribution of excursions for that stock, it is considered significant. Here is an example. If it is normal for a stock to make an excursion of up to 2% on either side of a 50-day moving average within a period of 100 days, then an excursion of 3% below the moving average would be significant. Refusing to sell on a significant negative event will not stop the decline. It will only cost you money. People do not like to admit they are wrong. They cling to the hope that the stock will eventually live up to expectations.
Now assume that the distribution of a stock’s daily low prices about its moving average indicates that downward price excursions equal to or greater than 4% below the stock’s moving average occur only once in 200 days. Assume also that you are trying to capture the gains achieved by trends that last about 100 days. A spike of 4% below the moving average would be well outside the probability envelope of your investment time-horizon. That kind of price excursion would be a significant event. That is where a stop loss belongs. It would be foolish to keep holding the stock and hoping for a recovery. To do so would be blatant evidence of a lack of discipline. A disciplined trader would sell immediately.
For most people, the term "significant" is relative. It may mean a 20% drop from the purchase price for one person and a 7% drop for another. For our own traders, it is an event that is "statistically significant." They have learned to look for events that cannot be explained within the context of what is "normal" behavior for a stock. For example, say we flip a coin and estimate the odds of it landing on heads or tails. Obviously, a balanced coin will land 50% of the time on one side or the other. What are the odds that it will land on its edge? We would express the odds as 1 in so many millions, or billions.
A stock's fluctuation about its moving average can be expressed as a probability distribution. Statistically, if we measure the stock's price behavior and determine that its standard deviation is about .858 points (you don't have to know what this means, just follow along), then we know that it will be "normal" for it to vary by about 2 points within 100 days. How do we know? We know that, in a "normal distribution," a variation equal to about 2.33 standard deviations occurs about 1% of the time and that (2.33 x .858 = 2). The fact that a deviation from the norm that is equal to 2.33 standard deviations occurs about 1% of the time is true of all "normal distributions," regardless of the magnitude of a standard deviation. Similar computations can be made for any amount of deviation from the norm. The result of all these computations is a bell curve. The shape of this curve is the same for all normal distributions. This is a fact of mathematics, just as Pi is always equal to 3.1415926535….Thus, we can set our stop-loss at such a distance from the stock that there is only one chance in a hundred that it will be triggered because of the stock’s normal fluctuations, or we can set the odds at one in two hundred or at some other probability level. First, we have to determine how much "noise" or random fluctuation there is in a stock’s behavior. Then, we place the stop just outside the probability envelope of the "noise" generated by its normal day to day fluctuations. Such a setting assures us that if the stop is triggered, it is because of a price surge that is not normal for the stock. We can determine just how abnormal a surge will have to be to trigger a sale.
Though market behavior is not strictly "normally distributed," it is close enough that we can make useful estimates of probability. Setting your stops on the basis of mathematical probabilities enables you to distance human emotions from the decision process. You don't have to agonize over whether the stop is being set too far away or too close. You can have confidence that you have placed it where it should be placed, and that if it is triggered it is because the stock's behavior has been abnormally deviant, beyond the realm of probability, and beyond your comfort level.
Dr. Winton Felt maintains a variety of free tutorials, stock alerts, and scanner results at www.stockdisciplines.com has a market review page at www.stockdisciplines.com/market-review has information and illustrations pertaining to pre-surge "setups" at www.stockdisciplines.com/stock-alerts and information and videos about volatility-adjusted stop losses at www.stockdisciplines.com/stop-losses