A stop loss is a line in the sand price at which a trade will be closed. The stock price must fall below the stop loss price at some time after trade entry to trigger an exit. Also known as a fixed stop, the stop loss is placed under the trade entry price. It serves to limit the maximum loss a trade can incur.
An exit strategy is different in that it is generally accepted to be a means to exit a trade at a profit. That is, the exit strategy is designed to be placed above the trade entry price and will trigger a trade to exit at a price above the entry price.
Many sources discuss the use of a 10 or 15% stop loss. The aim of the percentage is to limit the amount of capital at risk in any one trade to 10 or 15%. However, there is also a line of argument that says a 10-15% stop loss will cause premature exit from a trade.
In other words, a tight stop loss raises the likelihood that the trade will be exited before the stock has had time to oscillate into profit. This creates a conundrum. On the one hand a stop loss is required to protect capital, and on the other, it can cause bit by bit erosion of capital through multiple small losses when the 10-15% stop loss is repeatedly triggered. This can be particularly frustrating when a trade reverses to the upside just after a stop loss is triggered.
One answer to mitigating the early exit caused by a stop loss, whilst retaining capital protection, is to size the stop loss according to the average or typical swing percentage seen in the stock price in recent times. To calculate this is a matter of reviewing stock charts and assessing the percentage price change from high to low across normal week to week or month to month oscillations. If a stock regularly swings 3-4%, then a 10-15% stop loss is probably appropriate. If the stock regularly swings more than 10-15%, a 10-15% stop loss needs to be reconsidered. Another consideration here is the type of stock being traded. For instance, blue chip stocks are likely to be less volatile than speculative stocks – but not always. Essentially, we are saying a stop loss will likely need to be tuned to the personality of the stock being traded.
Exit strategies are many and varied. Another type is the trailing stop. A trailing stop is an exit price set below the current stock price and which moves up with the stock price, but cannot move down. Hence, if the stock price rises and then falls again, the magnitude of the rise in price is captured. However, one issue with a trailing stop is that the stock price has to move up by the percentage of the trailing stop amount before the trade is guaranteed to close at a profit. Take a stock at $1.00 with a 10% trailing stop exit. The exit price will be $0.90c. If a trader pays $1.00 for the stock, the price needs to rise beyond $1.11c before falling back to exit above 1.00 in order to close in profit (not including commissions and other costs). $1.11 – 10% = $0.999c.
Another consideration for profit exits, is to be aware of the phase of the market a trade is occurring in. Generally speaking, the longer an uptrend has been in place, the closer it is to ending. During an uptrend, stocks often surge for a period of time and then move into a sideways period before either returning to the prior trend or reversing the trend. There are many theories on how to read these consolidation and distribution moves. However, these are not in the scope of this blog to discuss. The important issue is to take into account the strength and consistency of an uptrend that is creating a profit and to know that wise investors often take profit while the going is good, rather than waiting too long into a reversal and losing substantial amounts of a profitable price rise. Of course, this is what the trailing stop is supposed to protect against. If and when a stock looks to be reversing it is wise to tighten the trailing stop from for example 15% during an uptrend to 5% during a protracted pull back. This will allow the stock to move down a little, but will capture a larger profit if price falls too far. The actual percentage for the tightened trailing stop is a matter of looking at the stock chart and assessing whether a pull back is a normal periodic swing or a change in the trend direction.
One way to assess this is to watch for the stock to form a lower high and a lower low. Here the trader watches for he stock price to form peaks and troughs. Once price falls below a prior trough and at the same time forms a lower peak, then it is more likely a new down trend has been established. There are no guarantees here. However, what we are trying to do is be objective and apply repeatable rules. Not to mention lower peaks and troughs are well researched and reading more about Dow peak and trough theory and Gann swings is recommended.
