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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Pathways of fate

Two roads converged in the woods and I took the one less travelled. And that does not seem to have made any difference! 🙂 🙂 🙂

In fact even Robert Frost, whose poem “The Road Less Travelled”, admitted that if he were to retrace his path and were to come upon that same fork, he was not sure if would make the same choice yet again.

Some poems, stories, books stay with you. Floating around in your subconscious. This is one such poem that I remember from my school days. I cannot recite the entire poem in one go, but I remember the theme and the imagery that it had left in my mind back then. “The Pied Piper of Hamelyn”, “The Highwayman”, “Hiawatha’s Wooing”, “Satpura ke Ghane Jungle“, “Jhansi ki Rani” are some of the others.

Speaking of personal paths, I had drawn the locus of my movements on Earth sometime back. In my much younger days, decisions of my elders moved me around on the paths that I was takinng. There was no questioning and full trust. And i have had a whale of a time. Later on, as I entered the last few years of my teens, the path that I took have largely been my doing – with useful help and advise from others. So if I should regret, its on me. If I should celebrate, its on me.

Here’s how my domestic path looks like. These are the cities that I have been to, spent time working and/or visiting. From all these places I have learnt something. Some good things, some bad. Transit cities are not shown. So, for example if my journey takes me to Xanadu en route to El Dorado, I would not show the former on the map.

And below is how my international footprint looks like. A lot to cover, a lot to learn. When a group of us friends had decided to take a snowed in break in Auli (Uttaranchal) we had met a guy who had been to 120 countries. One of us had wondered aloud if those many countries even existed in the first place. With the collapse of the Soviet Union and the formation of the various stans, I am sure this guy would’ve been thrilled. More to add to his travelogue. His Fodors was expectedly, very frayed.

So often we hear ourselves or our friends, associates fret and muse about choices and chances missed. About milk spilt. BTW, I don’t feel bad about any milk that’s spilled – because A) AMUL is not listed and B) I hate milk more than I hate luv storys. Coming back to the sombre mood, many of us love to regret, retrace and draw out imaginary probabilistic paths of alternate realities. Good fuel to feed the fire.

Does the Buddhist Baggio regret not hitting the target during the penalty shoot out against Brazil in the 1994 FIFA World Cup? Columbian Andres Escobar was not even allowed to be around to regret his faux pas of scoring an own goal against the USA in the same tournament. He was shot. And then some personal anecdotes that I have lent a sympathetic ear to:

“If only I had listened to my inner voice and pursued architecture from Sir. J.J. School of Art, I’d have been so much more successful. But my father wanted me to be an engineer”.

 

Kaash hum kuch aur padh lete bachpan mein. Hum bhi private gaadi ke driver hote, parking attendant nahi. Driver hone ke liye kabhi kabhi angrezi aani chahiye“. (I wish I could have studied. I would also be a chauffeur today instead of a parking lot attendant. Sometimes, knowledge of English is required of a chauffeur).

 

“If only I had waited for the birth of my son. I would not have to give up a promising career and become a housewife”.

Charles Dickens gives us young ‘uns some hope when he says that “Regrets are the natural property of grey hairs”. But then there is a perplexing (to me) remark from Henry David Thoreau telling us that “To regret deeply is to live afresh”.

 

Here are two paintings – which one is regret and which one is sorrow?

        

 

 

Sorrow and regret seem to be two sides of the same coin. Maybe nothing cleaves the two. But regret is not the same as guilt. See the painting alongside – is it regret or sorrow or guilt?

 

 

One lesson that I have learnt from my investment related readings is this: When life gives you lemons, don’t make lemonade. Just cut your lemons (i.e. losses) and run.

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