“Because I always get stopped out”

If I’ve heard it said once, I’ve heard it said a thousand times. And the reasoning never changes. It implies regret at stop-losses being triggered which, in turn, suggests that the shares tended to bounce back.

I understand the logic; I appreciate the frustration. Annoyance at being stopped out, forced to take a loss, missing out on the share price recovery. Maybe the shares got back to break-even. Perhaps they would even have gone on to turn a profit.

However, this hindsight focuses purely on the opportunity lost from the shares recovering. It conveniently ignores the risk that the share price could have fallen much further (I write this assuming a Buy/Long position).

In your trading, how many times have you been stopped out, and the situation became even worse? Traders have a tendency to recall profits made and blank out losses. They similarly remember profits missed (but correctly called of course) and forget bad calls/losses avoided. It’s an ego thing.

Two questions

Stop losses are a powerful trading tool

“Have you considered whether your stop-losses were too close?” By this I mean were they placed within the realms of possibility for the shares’ daily volatility? If so, was there a strong chance that the stop-losses would be triggered?

Secondly, and similarly, “Were your stop-losses at or very close to recent/prior lows?” By this I’m making the observation that if the shares traded there very recently, they could very well have traded there again.

Stop-losses are designed to exit a position at a worst-case-scenario, when the shares are no longer trading as you expected. Perhaps they breached a support trend-line. Maybe they reversed an uptrend. Whatever, things don’t look as good. As much as they exist to protect from losses when things go awry, they are also be used to protect profits from being eroded.

While the situation could of course improve they could just as easily get worse. And “hope is not a strategy”, meaning the possibility that the shares bounce back isn’t necessarily a valid enough case for hanging on and shouldn’t outweigh the risk of taking a bigger loss. After all, your money remains tied up, unable to be used elsewhere to generate profit, and your hope is only that things get back to break-even.

Options for Stop-losses

Stop-losses are a form of protection

Firstly; trade with no stop-losses. Risk the share price falling, even plunging.

Note CFDs require a minimum 20% margin. If the margin available falls below 10% (50% of required margin) because the shares have fallen by 10%, automatic stop-losses close positions for a 10% loss, preserving the remaining 10% margin. If the shares plunge by 25% automatic stop-losses close positions for a 20% loss, using all available margin, ensuring you cannot lose more than the value of your account. Any extra funds/margin on account merely increase the buffer before the position is closed automatically.

Secondly; place your stop-losses a little wider than you might normally (e.g. 4% versus 3%, or below recent lows). This increases any potential loss, but also reduces the chance of the stop-losses being triggered earlier than you’d really want. It provides more breathing room and allows the shares to trade recent lows again before bouncing back.

Thirdly; Place your stop-losses much wider (e.g. 8% versus 3%). The shares would have to drop considerably more for your stop-losses to be triggered. And if they do get triggered, something big has clearly happened. Do you still really want to be in the trades? Are the companies still the same, worth the same? Do the shares warrant a return to where they were?

Hope vs. conviction

If your answer to any of the latter questions is “yes”, “because the shares might bounce back”, remember what we said earlier. Wouldn’t it be better to be out by using stop-losses before things get any worse, keeping your powder dry, waiting for a better entry point, until you’re sure its worth going back in, or even to trade something else?

Stop-Losses example

If you really believe in a share price recovery, why not buy back in (more?) at the new depressed price, in order to profit from the recovery? Remember, when holding on for break-even a 10% decline is only offset by an 11% recovery. A 20% fall requires a 25% rally. A 30% drop can only be neutralised by a 43% rise. A 40% fall? 67%! And so on. And that’s just to break even. A lot of hard work just to get back to zero. And no guarantee that things don’t get worse before they get better, all the while tying up your available capital.

As I said earlier, “hope is not a strategy” which marries well with another adage “let your profits run and cut your losses”. A few decent profits versus a few small losses makes for a profitable trader. Stop-losses (normal, trailing and guaranteed) are valuable trading tools when employed correctly. Don’t knock ’em until you’ve used them properly.

Mike van Dulken, Head of Research, 7 Nov 2018