This is a reprint from 2003, originally published at MarketWatch:
NEW YORK (CBS.MW) — The Duke of Wellington once observed: “What makes a great general? To know when to retreat; and to dare to do it.”
The same thinking applies to investors. They must understand when to “retreat,” and have the self-discipline to do so. This is especially true in the present environment. The pre-war “spike” last month shows why. Eight straight up days, with gains of more than 13 percent, makes it too easy to become complacent and forget about risk management.
Once the market lurched into rally mode, I’ll bet many investors let their emotions get the better of them. Ask yourself these questions: Did the best week in over 20 years suck you in without a coherent exit strategy? That stupendous run was followed by the single worst day in over a year. Was it only then you discovered that you had no contingency plan?
Perhaps, then, its time you developed a risk management strategy – including a sell discipline.
A Strategy for Every Market
Bulls and bears alike need to preserve capital and manage risk. These tactics are crucial regardless of whether the market is crashing or rallying, whether there’s a war on or the economy is in recession.
Take the present environment. From studying market history, I believe that major crashes (think 1929 and 1972-74) are followed by years of range bound trading. Until I see otherwise, I expect growth to be anemic, deficits to keep increasing, and business spending and hiring to remain weak. There’s still too much capacity, too much debt, and the increasing possibility of deflation. Despite this, stocks are not at historically cheap valuations. On the bright side, interest rates are at 40-year lows, and that makes present equity valuations a bit more sufferable.
These crosscurrents make it all the more imperative to have a reliable plan – before you run into trouble.
Risk management methodologies are designed to help you avoid devastating losses. The stop loss is the most basic tactic in your arsenal. Stops work because they define losses in advance. They provide an investor with an objective set of criteria for selling any position. This allows an investor to exit a holding before becoming emotionally involved.
Whenever I review a portfolio down 50 percent or worse, I know I’m seeing the handiwork of an investor who lacks a sell discipline.
Why are stop losses effective? Simply stated, there’s only so much any stock can do. It can go up a little or down a little. It can go up a lot — and here’s what is so devastating to portfolios — it can also go down a whole lot.
Investors who avoid the last scenario spare themselves the kinds of losses that are difficult to recover from.
Let’s look at some specific stocks to see how individual investors can apply different types of stop loss principals.
Percentage stop loss
The percentage stop is the simplest of all stop loss strategies. It limits your downside risk by a predetermined percentage of the purchase price. Typical stops range between 8 percent and 15 percent. Longer-term investments can use stops of 20 percent. That will keep you in a stock if a minor pullback occurs, but take you out in the event of a total collapse.
Let’s say you share my expectation of anemic GDP growth over the next few quarters. In those circumstances, one would expect the discount retailers to do well. A favorite in the group is Target (NYSE:TGT) , down well over 33 percent from its 12 month high of $46. We recently looked at Target near $29. If you purchased the stock at that price, your 15 percent stop loss would be $24.65. Any day the stock closed at or below that price is your signal to sell.
Of course, no one has a crystal ball. This idea could be wrong in many different ways. Perhaps the thesis that the U.S. undergoes an anemic recovery is off. Maybe the conclusion – that discount retailers do well in that environment – is wrong. Even if the economic thesis and sector conclusion turn out to be correct, perhaps we just picked the wrong stock from the group.
Regardless of the reasons, once Target trades through my stop point, we part ways. I sell the stock, book a small loss, and wait for the next opportunity.
Stops set below an up trend
Another method of stop losses I like to use is placing a stop just below an up trend. This is a technically based loss limit. It’s designed to liquidate a position in the early stages of institutional distribution (a technical term for mutual fund selling).
For stocks in long-term up trends (remember those?), place your stop loss just below the trend line. They’re easy enough to find. Use a daily or weekly chart, and draw a line connecting the three most recent lows. Place a mark a short way below that line, on the far right side of the chart. That’s your stop loss.
This stop should be monitored as the stock price rises. Review it at least once a month; Active traders review their stops more often, typically weekly (or even daily).
Lets look at some active stocks as examples.
In early 2003, the Nasdaq 100 (INDEX:NDX) stocks were holding up much better than comparable S&P 500 stocks during sell offs. That “relative strength” suggested these NDX stocks would outperform when the markets turned around. Lets look at one popular NDX stock: Nextel Communications (NYSE:S) .
Since narrowly avoiding death last summer, Nextel seems to have regained its footing. Although still way off its all time highs of $80, the stock has maintained a steady up trend on its weekly chart since June 2002, closing at $13.39 on Monday. Holders of Nextel would place their stop losses just below that up trend, at about $10.25.
For stocks in downtrends, the reverse is true. You can place a “buy stop” above the trend line. Hedge fund traders use often a break of downtrends as a signal to cover short sales.
Take the defense sector as an example. Defense stocks rose more than 300 percent from their January 2000 lows to their highs in June 2002. But since peaking, the sector has retraced 40 percent of those gains.
I find it intriguing that investors were dumping defense stocks – or even shorting them – right before a war that may last a long time. Lockheed Martin (NYSE:LMT) is a good example. The break of the recent downtrend was a strong signal for shorts to cover their positions. It might have even been a buy signal.
Stop loss below support
You don’t have to be a technician to see where support is on a chart. Look for the horizontal line that a stock often trades down to, then bounces off. That line reflects the price where institutions find the stock compellingly cheap, and have reliably bought it in the past. Their buying is what usually supports the stock from falling further.
Your stop loss goes right below that level.
When a stock breaks support, it means that institutional thinking about the company may have changed. That break often indicates the stock will head further south.
Buying a stock right above support, with a stop just below, offers a good risk/reward set-up. Downside is limited to a few points, while upside may be substantial.
Oracle Software (NASDAQ:ORCL) is currently trading above its support in the mid $10s. As long as it stays above the $10.50 level, I’m happy to own it. Breaking that level suggests a new, lower trading range. Once that happens, I cut it loose.
Take another look at Nextel, only this time use a daily chart instead of a weekly. It reveals a well-defined trading range between $11 and $14. A buy at the bottom of the channel ($11) would set your stop loss just below support – at about $10.50.
Stop below moving average
One of the most reliable sell signals is the 200-day moving average, or MA. The MA is the average daily closing price of a stock for a specific number of days.
When a stock is rising, its moving average will rise, albeit at a lag. Once the stock begins to falter, its price will fall much faster than the moving average. When the share price crosses the average to the downside, that’s a very powerful sell signal.
Since the market peaked in April 2000, every major disaster — from Enron to Global Crossing to WorldCom — has given clear 200 day moving average sell signals. Every single one.
Lets look at Halliburton (NYSE:HAL) , a heavily shorted oil driller due to asbestos liability concerns. Since it crossed its 200-day moving average to the upside (around the November elections), short sellers have been covering their positions. Just as a downside cross is a sell signal, an upside move through the 200 day often generates a buy signal. Indeed, short sellers often use the 200 day as their “line in the sand.” When a stock crosses the 200, they cover their short positions.
If you were short Halliburton, the cross above the 200 day was your stop loss. If you are presently long Halliburton, you could place your sell stop loss below the 200 day – at about the $16.50 level.
Any stop loss can be turned into a “trailing stop.” This strategy prevents you from giving back the gains of a winning position.
As a stock rises, you raise your stop loss with it. One strategy is to increase your stop each time the stock enters a new “decade” (forties, fifties, sixties, etc.). Adjust the stop loss based on the weekly – or even monthly – closing prices. This makes it more likely you’ll get the benefit of a rising stock price for as long as possible, while still offering downside protection.
When moving your stops up, it’s a good idea to avoid using round numbers (i.e., 60, 70, 80) because option strike prices can temporarily “pin” a stock to those levels on expiration day each month. There’s a tendency for stocks to trade to just below these levels, and then snap back. For lower priced stocks, try using weekly increments of $5 instead of “decades.”
Prudent investors decide on a sell strategy before getting involved with a stock. They use objective decision-making criteria to keep their emotions out of the process. Like experienced flyers, they know where the emergency exits are before trouble arises.
You can think of stop losses as the “pre-nuptial agreements” of the market. Sign one before you marry any stock (no lawyers required!). You can even use CBS MarketWatch Alerts to send you an email when your stock hits your predetermined sell point. See Alert Watcher.
Stocks almost never collapse overnight. It took shares of Enron , the mother of all disasters, over a year to go from $90 to zero. Without a sell strategy in place, many shareholders were frozen by fear. They rode Enron all the way down. Had they used any of these stop strategies, their losses would have been small to moderate.
That’s the value of risk management. It recognizes that not all investments go your way. Identifying in advance that some stocks will be losers will save your self a lot of grief in the long run — and a lot of money.
(2003 Disclosure — Editor’s note: At the time of publication, Maxim’s clients had long positions in these stock mentioned: Halliburton, Lockheed Martin, Nextel, Oracle, and Target. All expressions of opinion reflect the judgment of the equity research department of Maxim Group LLC at this time and are subject to change. Barry Ritholtz can be reached at email@example.com ).
Volatile markets call for stop-loss orders
Commentary: Using stops to limit risk, protect profits
April 1, 2003, 12:02 a.m. EDT
By Barry Ritholtz
(Editor’s note: Barry Ritholtz is the chief market strategist at Maxim Group, which manages over $4 billion).