Stop Losses

Many investors err when they end up throwing good money after bad. The temptation to average the costs down has weighed down on most of us. The problem with this tactic is that it works only when you have studied the underlying asset very very thoroughly. Most of us do not do this. Most of us are not equipped to do this. Most of us do not have the time nor the patience to do this. The other mistake that many investors make is that they get into a position without having pre-decided their stop losses. Or ignoring the stop losses when confronted with a losing proposition.

Almost all of us would have had someone in our extended family or friend circle who might have been badly mauled by the markets and would have consequently vowed never to return. It’s not their trades or the risky nature of the markets that did them in. It’s their lack of discipline. So many times we hear the refrain that markets are too risky. Actually, the market is not risky at all – it is the behaviour of the investor that is risky. The market never induces you to buy. This weekend when I was in Bombay, my mother told me about the losses that my father had totted up during his investing misadventures. Luckily for us (my brother & I) he did not sell off his losses, he just ignored them. And these shares (most of them cyclicals) passed on to us after his demise. And wow! The cycle turned in 2002/03 and how! Imagine riding Steel Authority of India Limited from 6 to42 in a period of 18 months. That hooked me for life. Till the losses tested me.

It does not matter when you buy, it’s when you sell that’s most important. This post is one amongst the various efforts on my part to understand the full meaning of this sentence as per my 5Aug resolution. One can get out of a position making a profit or else leave the table with a loss. Stop losses are signposts that help you decide when to sell if your trade does not work out the way you intended it to be. There’s no emotion involved, just hard nosed, dispassionate, stoic discipline. Statistically, mostly men/boys invest – so much so that investing might seem like a male thing to do. But successful investing is really quite machinistic and dull. Stick to one trading system, do not flip in and out. Stick to your stop losses. Write down/visualise your goals for each position. Maintain a trading journal recording your behaviour and why you did what you did kind of thing. Boring. Please read this cool article which talks about the 5 uncommon rules of the really wealthy traders to get some sense of how boring trading can get! Putting money in a bank fixed deposit or better still a ULIP can be so exciting! You’d get all the time in the world to party.

Sometime back I saw the movie Kites. Kabir Bedi, a powerful casino owner plays the father of Nick Brown who tells this to his revenge driven son when the woman whom he was to marry elopes with Hrithik Roshan:

“The true gambler is the one who knows when to get up from the table”

The other anecdote that comes to mind is from a job interview that I had conducted for a senior position in my company some time back. The candidate was trading on the prop account of some agency and among other questions I had asked him about his trading style and attitude towards stop losses. The guy said that he had never ever violated his stops. The two people who reported in to him had busted their stops one time each. I don’t care if this was just for the effect but inspiration strikes from the most unlikely of places. I have read quite a few books on trading, psychology of trading but when I met this “pretending to be in control” guy I thought that if this chap can do it, why can’t I. I’ve respected my stops ever since – hopefully it will become a habit.

This is important since stop losses can protect you even if you suddenly get whiplashed by a sharp correction. In fact its quite cool since you will quickly be in cash and hopefully will be able to redeploy and make more than what the stops cost you. Which brings me to important question: What should the ideal stop loss be?

The quantum of stop loss depends on what you expect from your investments and who you are. If you trade in and out intra-day (the post is not meant to be read by such people anyways) then your stop loss levels will obviously be extremely tight. Maybe 1% – 2%? There’s a lot of material on discussion forums and websites which points out to 2% being a good rule of thumb. But I feel that if one trades for longer periods, across multiple settlement periods a level of 5% is good enough. The volatility in Indian stocks is high enough to justify a 5% stop loss level. This point is important since if you are an infrequent trader then there is a danger of getting whipsawed if you put too tight a stop. Putting too tight a stop is like writing an annuity cheque to your broker. Your choice of stop loss ideally should be predicated by:

  • your risk appetite
  • risk in each individual position
  • volatility of the position
  • the amount of capital locked into the position
  • market conditions – if you want to go long in a bearish market, it’s absolutely essential to impose tighter stops.
  • time frame for the trade (discussed above)
  • Bravado (best if this reason be read and forgotten)

 Mental stops do not work. Period. I have done some conditional formatting and alerts on my trading spreadsheet and the annoying things keep popping up reminding me to cut my losses and run. You could have your own custom system, more sophisticated than mine, but do not do it only in the mind. It’s easy to overrule one’s mind.

This piece is obvisouly written for people like me. Casual traders. Folks that have a day job and who can afford to look at stock prices only a couple of times a week when the market is on and perhaps 3 – 4 times a week at night while the market sleeps. Folks who want to flog their investible surplus for some alpha instead of letting it rot in bank deposits. The Anirudh Sethi Report, which incidentally became the first site to link to my website has a cool example of how stop losses can be used to make money a la big game shooting. The lesson is almost like a Zen Koan. In fact, Zen masters would make awesome traders.

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About Kaushal
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5 Responses to Stop Losses

  1. smallivy says:

    Nice article and a nice blog. I’ll add a link from my site.

    I’ve found that stop loss orders can be dangerous in their own right (like the day of the flash crash). It sometimes is better just to have firm rules and follow the stock.

    If you get the chance, come check out my blog: http://smallivy.wordpress.com.

    Like

    • Kaushal says:

      thanks – will link as well. site’s awesome – will borrow & attribute ideas/writing style/investing gyaan (i.e. knowledge)
      flash crashes though (like the cloud burst in Mumbai on 26Jul05) are black swan events, right? But I do agree that traders will get wiped out if you start having more of these in quick succession. I think program trading is not quite prevalent in India though it should get more common in the future given the rapid rate of absorption of ideas/culture/tech into India/China from the US.
      The Indian scene is still a rising saw tooth kind of waveform. Corrections are short, swift and significant (in %) while the recovery is at a more measured gradient.

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      • smallivy says:

        By “black swan event,” you mean uncommon (I’m not familiar with the phrase), then yes, it may be a once-in-a-lifetime event. It really caught some people with stop loss orders in by surprise though, because the prices of stocks dropped 50% or more, at which point they sold their shares because of the stop loss orders, then the stock jumped back to where it was.

        I’ve found in general though that if you use a lot of stop loss orders you’ll miss out on the big events. You’re trading based on the market, rather than the fundamentals, so that great stock you bought may take a dip because someone decided to unload some shares just before the company releases the great earnings and proceed to climb 1000% over then next several years.

        Probably the best place to use them is when you’re ready to sell some shares anyway but just don’t have the conviction to sell them. I usually find, though, that I do better if I just sell the shares since by putting in the stop loss I end up giving up a dollar or two anyway. I rarely see the stock move higher before hitting my stop. Some market makers may have something to do with this….

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      • Kaushal says:

        Agree with you Sir. I’ve ridden some positions that have been 18 baggers for me (yes! it’s true. anything’s possible in India 🙂 ) and I would have definitely lost the plot if I was fixated to the stops (or even escalating stops for that matter). But in those trades, I had strong conviction.
        I guess given all the uncertainty and the fact that my capital has also increased now, my nervousness is not letting me have the same conviction that i had earlier. I want to take modest profits and run. While I would end up paying more taxes and brokerage, at least I keep banking now and then. I have one position where I have a lot of conviction and there I am quite indulgent on my stops.
        Recommend, Taleb’s The Black Swan – there are so many sequels and spin-offs by other authors cashing in on the popularity of the phrase. The engineer in you may like the book. Thanks for writing back.

        Like

      • MJ says:

        So you guys are debunking the “random walk” hypothesis? Me too!

        Like

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