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Stop Loss

How to protect investment capital and minimise losses?

Stop Loss, Initial Stop, Trailing Stop

Okay, you have some money invested in shares, or a managed fund, or
some other financial instrument (eg. bonds, currencies, commodities),
and the value of your investment is falling.

What if the value of your investment falls by 50% or more? or 90%?
Should you consider selling it?

The notion of a Stop Loss is relevant, and very worthy of consideration.  Read on...
 

Stop Loss - what is it?

A Stop Loss is a price level at which you would consider selling your investment. It's purpose is to protect your investment capital by protecting profits, and limiting losses.

But, how useful is it?
Babcock and Brown

Example#1 - BNB (Babcock n Brown)

Take a look at the price chart of Babcock and Brown (code:BNB) at right - click on the image for a larger version that is easier to see.

BNB fell some 84% over about a year in late 2007 and early 2008. All the way down, investors in this stock had an opportunity to exit the stock before it delisted in June 2009 - gone! By January 2008 when the BNB share price showed a "Lower Low" on the price chart, a down trend was confirmed.

Anyone with a Stop Loss level set at maybe $25 or $20, could have triggered a sale and held onto a lot of their capital by minimising losses.

Telstra (TLS)Example#2 - TLS (Telstra)

Take a look at the price chart of Telstra (code:TLS) at right - click on the image for a larger version that is easier to see.

TLS has had three tranches of public float since 1999 when the share price touched $9 - the floats referred to as T1, T2 and T3. By 2010 the share price had fallen below $3!
 
Even though brokers and analysts were recommending that the public take up each float option and purchase the stock, the share price has continued a down trend over at least a 10 year period. Whilst any stock is down-trending, many traders would not buy it. Anyone who did hold TLS could have set a Stop Loss at a number of price points on the way down in order to liquidate before further price falls. The price chart shown here shows TLS in a down trend - in which most traders would not invest (except for very short term gains on the short upswings).

How to calculate a Stop Loss level?

Unfortunately, there are many correct answers to this question, and they are all different. Just some of the possible methods (with comments) include:
  1. A specific percentage fall in price - eg. 10%.
    This arbitrary method is very fallible because a stock might find support lower than 10% below current price, and then rally upwards to new highs.
  2. Chart pattern - at a recent Support level.
    This is a clever approach, and utilises the technical analysis notion of price Support levels. For more information about chart patterns, see relevant eBook Articles on Technical Analysis, or the "Blue Chip Price Chart Secrets" handbook (at right).
  3. Technical chart indicators - eg. Parabolic SAR, and Wilson ATR Trailing Stop. Along with chart patterns, this is one of the more clever approaches because the distance of the Stop Loss level away from the price can be automatically calculated by the indicator, and is based on recent price activity.

Initial Stop

This is the first Stop Loss level that is calculated at purchase time. It's purpose is to identify the point at which you would exit the stock if the purchase decision turns out to be a bad one. Traders tend to purchase a stock in the anticipation of a rise in price. But if the price falls, and the purchase decision is proven wrong, then it might be prudent to exit the position.

Trailing Stop

After a stock purchase, and the price rises far enough, it is time to take the Initial Stop position and raise it to protect some of the earned profits. It then becomes a Trailing Stop, and it should be reviewed and raised every few days (or every week or two) to continue to protect more and more profit.

Implementing your Stop Loss

In order to implement a Stop Loss, there are two basic approaches:
  1. Mechanical Sell - Place a conditional sell order into the market so that if the stock actually trades down to your Stop level, then a Sell order is triggered, and (hopefully) the stock is sold. Note: A conditional sell order is not guaranteed unless explicitly arranged with the broker.
  2. Discretionary Sell - Monitor your stocks periodically (according to your written Trading Strategy), and if the stock closes below the Stop Loss level, then consider selling in the next trading session.

More information?

For more details about Stop Loss, see the Share Market Toolbox links at the top of the column at right.

More Information

Slide presentations - There is some preliminary and basic information in some of the slide presentations that Robert has prepared and delivered at various meetings.
eBook Articles - Share Market Toolbox Members can see more details in the following eBook Articles:
(Toolbox non-Members can see the "Page 1" of these Articles from the Master List page.)

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Terminology
There are a number of terms that are used in the text at left, including: Stop Loss, Support, Parabolic-SAR.
 
There is information on these in Brainy's eBook Articles. See the Master Index list for details.
 
Or, search the eBook Articles.
The Share Market - more information about the market and investing and trading.
Brainy's Share Market Toolbox
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The information presented herein represents the opinions of the web page content owner, and
are not recommendations or endorsements of any product, method, strategy, etc.
For financial advice, a professional and licensed financial advisor should be engaged.

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Last revised: 5 July, 2011.