The Virtues of Stop Losses

Kevin Lane is one of the founding partners of Fusion Analytics, and is the firm’s director of Quantitative Research. He is the main architect for developing their proprietary stock selection models and trading algorithms. Prior to joining Fusion Analytics, Mr. Lane enjoyed success as the Chief Market Strategist for several sell side institutional brokerage firms. In those capacities he oversaw the firms’ research departments. He produced a broad range of widely followed institutional research publications ranging from industry specific notes to quantitative/fundamental reports on individual stocks. His buy side clientele consisted of many of the nations top money managers and hedge fund managers. Mr. Lane is a member of the Market Technicians Association.

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I recently had a conversation with a money manager and we discussed the virtue of stop losses. I hope I am recalling the story with as much accuracy as I can. If not the general theme would be the same had the characters been fictitious.

Anyway he went on to tell me about a protégé of his who worked as his under study for several years before going off on his own. He described his under study as a very good stock picker with a knack for finding great winners. However like most investors he had one problem when the markets turned south (as they inevitably do sometimes) he had a hard time separating the idea that even good stocks could get taken apart if a broad market correction. Even with riding out several significant market corrections over the years the manager had an enviable track record. However like most people this year the manager really got pasted. His old friend and mentor asked him ” Didn’t you have any stops on your positions ? ” The younger under study answered ” No not really as I felt the companies I owned were good companies.” Alas the companies may have been good however the market took many of them down 40 to 50 or more percent.

The more seasoned manager said to his young counterpart, ” Do me a favor reconstruct your portfolio holdings over the last 10 years and see what would have happened had you always employed a mechanical stop of say 10.00 % after entering a position. So the younger manager methodically cataloged his portfolio then reconstructed it with 10.00 % STOPS. The results were incredible not only did they save his butt during the major downdrafts they also extricated him of some of his portfolio laggards in up markets. The moral of this story is not that stops are the end all be all, but rather if you methodically and mechanically stick to your discipline your results will be smoother and with less volatility and you won’t let any bad investments get too bad !

As for me here is how I employ stops. I used key technical levels or support and resistance. I typically don’t like fixed %’s as many times just normal trading volatility can take you out of the name only to watch the stock then proceed in the original direction you thought it would.

So in my process before entering any trade I calculate what my upside price target would be for a stock (typically this is done by calculating a point and figure target and/or a valuation derived target). Once I formulate my target I then look to determine what my exit strategy (ie. stop out point) will be in the event I am wrong. Next I calculate what my % loss (draw down) would be. If the risk/reward ratio of the projected upside target relative to the drawdown point is greater than some ratio 2:1 or 3:1 for example then capital is deployed.

The key of course to making this all work is sticking to the plan (over and over and over again). That’s the hard part not letting the emotion in one moment keep you honoring a stop then in the next keep you from ignoring it.

So whether you employ a method such as mine or a fixed % method the bottom line is you should never operate on the high wire (ie. invest) without a net (ie. a stop)

Going back 10 years may be too time consuming without a staff but I would suggest you look at every trade/investment you did in the last 12 months. See if you exited them after they went 10.00 % against you and see if you would be better off. You probably will be surprised by how much !!

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