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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 technical 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 (see more details about Support and Resistance). It is also believed that support can occur at the base of a tall white candle (ie. a Big White). For more information about the related topic of chart patterns, see relevant eBook Articles on Technical Analysis, or the "Blue Chip Price Chart Secrets" handbook (at right).
  3. Count Back Line (CBL)
    This tool was made popular by Daryl Guppy.
  4. 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.

ATR chart indicators to determine a Stop Loss

Some people believe that an automatic approach to calculating the Stop Loss position, is simple, and as good as any. By using a technical chart indicator, your price chart can be automatically updated each day you look at it, and the value to use for the Stop Loss is shown on the chart without having to think about it. It is clear-cut, and there is no subjectivity.

Consider this. In normal healthy trading a stock will whip saw up and down by a certain amount. And over time, we can measure the amount of price variation up and down over several trading days or weeks - we call it Average True Range (ATR). Now if the stock falls by more than about 2 or 3 times the ATR, then it is outside it's normal behaviour, and it might be weakening and starting a down trend. So if we can flag this increase in volatility (ie. the increase in the range of the price), then we can identify possible weakness before it takes hold.
Now this approach makes a lot of sense.

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.
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See a list of contents on
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Beware the sharks in the ocean.
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beware of the sharks in the ocean!

Some samples

Sample ATR Many of the available chart indicators for stops are based on Average True Range (ATR). The ATR is a dollar value which describes how far up and down the share price has fluctuated in recent trading sessions. A common default value is to calculate the ATR over a 14-day period on a daily chart (or over 14 weeks on a weekly chart).

For example, let's look at a weekly chart of BHP as in the sample price chart at right with the share price shown as candlesticks in the lower half and the ATR indicator in the upper half (click on the chart for a larger image).

Note that BHP was trading between about $35 and $50 until it crashed to $25. The ATR indicator in the upper portion of the diagram shows that the BHP share price was moving from week to week within a range of about $3 to $3.30, and then the ATR value increased to over $4 with the volatile share price move downwards in September-October.

The Wilson ATR Trailing StopThe calculation for ATR is not a simple and straightforward calculation; but the chart indicators do all the calculating for us. The second diagram at right is a weekly line chart of the Macquarie Group share price in 2009 as it raced upwards from below $20 to above $55 (click on the chart image for a larger version).

The row of dots that rises across the chart is the Wilson ATR Trailing Stop chart indicator, based on a multiple of the ATR value of Macquarie Group. The idea is that near the right-end of the chart in early October 2009 when the share price was in the $50 range, the row of dots is positioned at $49.13, and basically says "if the share price falls to this value tomorrow, then the Stop Loss value is triggered and we should sell". This indicator can be easily adjusted to cope with more volatile, or less volatile, stocks.

Chart indicators for stops

Some of the more common chart indicators that are used to determine Stop Loss levels include the following:
  • Elder's Chandelier Exit
  • Elder's SafeZone
  • JB Trailing Stop
  • Parabolic SAR (Stop and Reverse)
  • Wilson ATR Trailing Stop
  • JB Volatility Profit Taker
  • NW Short Trailing Stop (ADX)
  • Chande Volatility Trailing Stop.

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 promptly.

Trailing Stop

After a stock purchase, and after the share 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 asap. 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.
This is one of the many tools in Brainy's Share Market Toolbox.

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: 16 October, 2012.