Learn to Trade the Markets : Part 2 (of 6) Stop-losses and profit targets

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“…Stops bring order and discipline to trading, allowing you to work within a system that rises above the swirling emotions engendered by the sight of falling stock prices. Just Mind the Gap…”

 

In this second in a series of six articles, we look at how you can look to trade the Markets, be it full time, part time or occasionally.

Every one reading  these articles will be at a different level compared to the next man. Fundamentally the rules are the same. Over 80% of retail “punters” lose money. Hopefully, here, we will try and help you be in the 20% that doesn’t.

We will cover different strategies, ideas, entry and exit plans and try and get you to just think a little more before giving your hard earned cash away. There is no right and wrong way to make money in the markets. Find a strategy that works for you.

The markets have been around for centuries, they are not going anywhere so take your time with your research. There is a plethora of information around these days with the advent of social media and the internet, use it. Ensure you have an exit plan. Any fool can buy a share, the trick is selling higher than you bought. We hope you find some benefit in one or some of the articles. The second article here features another very important topic : Stop-losses and profit targets 

“…Willingness to acknowledge a loss and sell is a psychological barrier all investors have to overcome…”

 

The first article in this series discussed the importance of buying a share with an exit strategy in mind: the price at which the stock will be sold, whether to take profits or minimise a loss.  We suggested a plan for cutting possible losses should be the first thing you should consider. Minimising losses on unsuccessful trades preserves the capital that allows you to continue to trade. The market will always yield fresh opportunities for making money, but your discipline in keeping your losses under control will allow you to stay in the game long enough to take advantage of them. Here we move onto Stop Losses and profit targets.

Setting a stop-loss

 

When buying a share you should think in advance about the price you are prepared to see it fall to before you write it off as an unsuccessful trade and sell. This price is called a ‘stop-loss’, or sometimes just a ‘stop’.

A stop-loss can be automatic or manual. Most investment platforms allow you to set an automatic stop-loss, the price at which the platform will execute an order to sell your shares without further input from you. You can also set a manual stop-loss, a price at which the platform will alert you – through an email or a text message – that a share has fallen to the price at which you should sell. It’s important to note that you will probably have to use manual stops for AIM shares: most platforms won’t allow you to place a stop on anything outside the FTSE 100 or 250 (though a spread bet firm might).

A stop-loss, whether automatic or manual, helps you confront the strong temptation to hold on to a losing share in the hope it will bounce back. Since trading began investors have found it hard to sell shares as they fall. Willingness to acknowledge a loss and sell is a psychological barrier all investors have to overcome.

Indeed many compound the issue by ‘averaging down’, buying more shares as they fall in the belief they are securing a bargain. Unfortunately if you hold on to shares as they fall it gets harder and harder even to recover to breakeven point – you are now up against pitiless mathematical logic. For example if a share falls by 25pc you need a 33pc return to breakeven. And if falls by just another 5pc you suddenly find yourself needing a nearly 50pc return. Your risk gets exponentially worse as your drawdown increases.

Deciding how much you are prepared to lose

 

Stops set boundaries to your losses, getting your out of a losing trade automatically, or alerting you when its time to pull the trigger (of course you must have the discipline to pull it!) Without them we are all prone to the temptation to hold on to a share in the often blind hope that it will eventually come good, losing more and more as the price falls. Stops bring order and discipline to trading, allowing you to work within a system that rises above the swirling emotions engendered by the sight of falling stock prices.

There is no hard and fast rule regarding to the level at which a stop-loss should be set. It really depends on how much you are prepared to lose on a trade and your assessment of the stock’s inherent volatility.

But there are a few well established guidelines. One is to set your stop a reasonable distance away from your buy price. If it’s too close you risk being ’stopped-out’, exiting your trade prematurely if the price of the share suddenly dips then rebounds, a notorious characteristic of AIM shares.

So you should check a share’s habitual movements before setting your stop. If a share is usually quite stable you might set the stop at 10pc. But if it tends to oscillate 10pc up or down for no particular reason you should go down to 15pc, or even a little lower.

When reviewing a share’s performance check if has a ‘support’ level, a price below which it tends not to fall. If for example a share tends not to dip much below 100p you might set your stop at around 90p or 95p to create a bit of breathing space below the habitual support level. The word ‘support’ of course is rather misleading – there’s absolutely nothing guaranteed about a support price! It just offers a guide.

Multiple stops

 

It’s a good idea to set more than one stop. You might set one stop for example at 5pc below your purchase price, and another at 10pc or 15pc. In his popular introduction to investing The Naked Trader Robbie Burns calls this first stop the ‘Get Out Quick’ (GOQ) price. A GOQ stop gives you the option to decide whether to exit a trade quickly if it begins to fall steeply just after you have bought it, allowing you to cut your losses immediately. 

And setting a GOQ can be very useful if you aren’t sure about a stock’s liquidity – how easy it will be to find a buyer for the shares you want to sell. Again, this is a particularly important consideration when trading AIM stocks, which as we noted in our last article can be illiquid (the market’s illiquidity is why investment platforms don’t allow automatic stop-losses to be set on AIM investments). If you are not sure you will be able to find a buyer when the price of your stock falls to its 10pc or 15pc stop, a GOQ gives you an opportunity to offload them before you get to that point. 

When using automatic stops something to watch out for is bad news that can hit a company after the markets have closed. Your share may open the next morning at a price well below your stop-loss. The company may for example issue a profit warning, be affected by another company’s news, or be caught up in a broader market development. It is worth checking news that might affect your share after the market has closed. An automatic stop of 85p on a share that you bought for 100p won’t protect you if the price opens at 70p – or lower – the morning after a profit warning. Some platforms do however allow you to reset your stop overnight.

Profit targets

 

You should also use stops to ensure you take earnings on a trade that has gone well. If a stock is on a strong upward path complacency can build, tempting you to mentally bank your profits before you’ve actually taken any of them. So a trade should be entered with a price in mind – usually referred to a ‘profit target’ – at which some or all of the shares will be sold.

Specifying a profit target is a somewhat more nebulous business than setting a stop-loss below the buy price. You’ll want to follow your winners as long as you can, so you don’t want to exit a winning trade too early. It makes sense therefore to set interim profit targets. You might allow a share to climb to at least 20pc before deciding to take some of your gains. You can then start ‘top slicing’, taking a portion of the profit – maybe a third, maybe half – and leave the rest of your money in until it hits 50pc. Of course if your research indicates that the share is likely to go on a long run you might want to ‘average up’ by adding shares to your holding.

Your platform will give you tools to help you track profits on rising shares. You can continually raise your stops on winners, locking in profit as the price rises. So if your 100p stock rises to 150p you can move the stop-loss up from 85p to something like 135p, thereby guaranteeing 35p worth of profit no matter what happens. You then gradually move the stop up as the price rises.

Some platforms allow ‘trailing stops’, stops that automatically track a rising share by a specified amount. For example a stop-loss of 15p might be set on a 100p share. If the price falls to 85p the holding is sold. If it rises to 150p your stop will be set automatically at 135p. If it rises to 200p it rises to 185p. When trailing a rising stock percentages can be set as well as absolute amounts. In the case above a 10pc stop will become 90p when the price is 100p, 135p at 150p, and 180p at 200p, and so on.

When tracking winners it’s important not to set your trailing stop too close to the current price. You don’t want to exit prematurely if the price suddenly dips before resuming its rise. Again, there is no hard and fast rule. 10pc to 15pc is a decent guide, but you will need to take note of a particular stock’s propensity for volatility.

Top slicing is particularly important for AIM shares because of the liquidity issue we mentioned earlier. If you have concerns you might wish to bank your winnings prudently, selling them bit by bit rather than all in one go, when you might struggle to find a buyer.

Exiting trades

 

Knowing when to finally exit a trade for good is something for which you will need to develop a feel for over time. A stock’s history can give clues. If its price keeps hitting a certain point without rising further, its a sign it is encountering ‘resistance’, and may be reaching the top of its upwards cycle. This may well be a good time to offload some or all of your shares.

You should also do your research, asking yourself if this is a stock you would buy at this price if you were considering it for the first time. Whatever happens you should never move your stops down on a winning trade. The point of them is to encourage you to take some profit when the share is high.

Deciding how much to risk on a share

 

Another important aspect of risk management is deciding how much of your capital to commit to a particular stock. Or to put it in the most brutal way: what proportion of your portfolio are you willing to lose when you buy a share? Our next article will look at the various strategies investors have developed for making that calculation.

 

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