Sometimes the best way of lowering exposure to risk is not to invest at all! However, when we make the decision to jump into the muddy waters of the stock market, its always a good idea to have a life jacket ready, just in case.
We all have stories of that “must have" “can't lose" stock that looking back, we didn't really need to buy, and it definitely lost. So, how to best protect yourself when the markets disagree with your due diligence? Trailing stop loss.
Its important to understand the psychology of investing. When we make money, there is instant euphoria. When we start to lose money, there is a sudden “deer caught in the headlights" type of emotion, which makes us unable to do the right thing. We fear that the moment we sell, will be the moment that it starts to rebound. Not only do we fear that we will be that guy who sold at the low of the day, but that we will miss out on untold fortunes because we got out too early.
While this happens, more often than not, a small loss turns into a much bigger loss. Remember, a 40% loss started off as a 5% loss.
So what is the best stop loss strategy? Well, we happen to have 2. One simple, one a little more complicated, but possibly more effective and capital saving.
The first strategy is called a “trailing stop loss". Its simple and effective. We're going to add a small twist to it. A traditional trailing stop loss simply means that you set a percentage that you are willing to lose. For example, if you purchase 1000 shares of ABC at $5/share, you could set a stop loss at 10%. This means that if the stock dips below 10% of your purchase price ($5 - 10% = $4.50), you're out of the market and no longer risking capital. If the share price moves higher, you would set your stop loss at 10% below the closing price. If ABC moves to $5.50, you would set your stop loss at $4.95. If the stock drops below that price, you're out.
By setting your stop loss at the time of your purchase, you are taking the emotion out of investing. Specifically, you are taking out the “deer caught in the headlights" emotion. This will save you grief and will save you money. If your stock moves like you think it will, you can lock in your gains automatically.
Our twist to this strategy though, is to first establish the dollar amount that initial stop loss is worth, and let that dictate what your stop loss will be.
Given the same example as above, your initial stop loss would be $4.50. You would only be risking $0.50 per share or $500. This represents the most you are willing to lose, regardless of which way the investment goes.
If the share price moves to $7.00, instead of setting your stop loss at $6.30, (thus risking $0.70 or $700 of your money), you would set your stop loss at $6.50, which risks the same $500 you were initially willing to lose when you first started.
This little twist helps you keep more of your profitable investments. Why put more profits at risk?
The second stop loss strategy is, although a little more complicated, will protect more of your money.
While we would love to take credit for this strategy, we found it when reading Chart Trading by Darryl Guppy. This strategy starts by looking at your overall capital, not the amount of the specific investment. For example, if you had $20 000 in your investment account, you could trade 51 times if each time you invested you put 2% of your total capital at risk.
While 2% doesn't sound like a lot, lets have a look at an example. Given your investment account has $20 000 in it and you only want to put 2% of it at risk, you would be willing to risk $400 per trade. This ensures that you will have 51 chances to get it right before you run out of money.
Where you set your stop loss is basically the point where you are risking $400. Given our initial example, your stop loss would be at $4.60. If the price moves from $5 to below $4.60, you have lost $400. What if you purchased 2000 shares at the same $5? Your stop loss would be then set to $4.80. Anything below that, and you have risked more than $400. If you think that you want a deeper stop loss, then you would purchase fewer shares. The idea is simple: you never risk more than the same amount per trade.
As the price increases, you then change the amount of your stop loss accordingly. If the stock hits $7, you would set your stop loss at $6.60.
Given our initial stop loss strategy, assuming you lost $500 each trade, you could lose approximately 40 times before you ran out of money. However, what if you purchased 2000 shares at $5 each? Your 10% stop loss would put $1000 at risk. This will lower the number of chances you have at getting it right.
Its up to you how much money you are preparing to risk. Many investors think of the ways they are going to spend their profits before they are made. Its much better to think about the amount you are prepared to lose. This way, when your hard work pays off, you'll appreciate it more. On the other hand, if the market disagrees with you, you can still keep the majority of your money!
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