|Some brokers and most spread betting firms now offer various automatic stop losses, ie if a price hits your stop loss they sell your position automatically. This sounds a good idea but in practice it does not always work like this.
Spread firms offer 2 kinds of stop losses -
- For example, if you bought BSkyB at 500p you could set a guaranteed stop loss at 480p which would mean you would be stopped at 480p however low the price went, or
- You could also set a normal stop loss so if BSkyB opened the day lower at 460p you would be stopped out around that figure. With a guaranteed stop loss you get the 480p, however you pay a higher spread (more cost) for this stop loss
- Automated stop losses can be good, but if you have access to a screen for most of the day it's better to control them yourself. If there is a sudden and unwarranted slide down to your stop loss, you can decide to hold rather than to be sold out automatically
I don't agree that tight stops offer greater security and are less risky and this is backed up by the many emails I receive. Guaranteed stops give your position less chance of being profitable because they are more likely to be triggered by random price changes and are therefore riskier. It is frustrating to have a position which stops out at a loss and then goes on to move as you expected.
A good example of this with my personal trading is a recent long position in Wolfson that I had. Brokers downgraded the stock causing a sudden fall but I knew from experience that in such cases the stock price was likely to bounce after the initial sell orders had been filled.
If I had been using a guaranteed stop loss my position would have been closed out. But as I was watching the price action I decided to do nothing which turned out to be the right move as the shares soon recovered.
The Myth - Tight Stop Losses Offer Great Security with Less Risk
Put simply, tight stops give your position less chance of being profitable. This is because they are more likely to be triggered by random noise price changes. As an example -
- If you were to buy ABC shares at 490p with a stop loss at 485p your risk is only 5p, but the chance of the shares moving down 5p is high
- But if you were to place your stop at 475p, although the risk has been increased to 15p, the percentage chance of a random price move down to this price level has been reduced
- Clearly however there has to be a balance to all of this which can only come with experience in the market place
- This is why it's so important for traders new to spread betting to start trading with small amounts of money
How to position the stop loss
The stop loss needs to be far enough away from the price to allow for some random movement but close enough to provide a safety net if you are wrong in your market analysis. The key to a successful stop order strategy is thorough planning. The problems occur when traders place bets on a whim and don't have a price target for the bet. In my experience, most spread betters fall into this category.
So how do I use stop-losses in my personal trading?
- For me the key is to have the stop far enough away from the price not to get whipsawed out of it, (using technical analysis to determine support and resistance)
- I then calculate 3% of my bank which is the maximum I would consider using, and normally only 1%, and I would never have more than 3 trades on at one time
- This is a conservative way to trade but I have found it to be profitable
Keep your Trade Size Small
My advice is to keep your trade sizes as low as you can and increase the size of your stop-losses. With investing if you are in for the long term (as you should be, otherwise you're trading) allow the stock to breath and place stops in a position that would be so far away from the price as to be highly unlikely to be hit.
You must use your money management to determine position size so if it was hit you would only lose a small % of your capital - do not invest more than 5%.
So to recap as to where to position stops, place them where they are unlikely to be hit, and adjust your trade size to suit. You'll find that you can go about your daily life without being chained to your computer.
Developing Alternative Risk Reduction Strategies
Another way to look at the problem of where to place your stop loss is to use a 3 step approach.
- Split your position into 1/3rds and sell 1 part if the price falls (say) 5%, the second 1/3rd at 10% and the final 1/3rd at 15%
- But when using this strategy it's important to consider the 'personality' of the share in question
- High-tech shares are often volatile whereas a large capitalised share like Tesco is unlikely to make a mega move over a few days
- A larger percentage should therefore be used with volatile shares (but with a small position size) and conversely smaller percentage moves with less volatile shares
You could also reduce risk by spreading your positions around, not just in different stocks but also having a mixture of both long and short positions.
Finally, make sure you understand your spread betting broker's policy on stop losses and how they are triggered. Are they triggered by the market price of a stock or by the firm's latest quoted price? My preference is for market price related stops because I can always see how far away I am from hitting them, whereas the firm's own quoted price can often shift around in an unpredictable manner.
Finally there are no concrete answers about where to place your stop loss. It all comes down to experience and your own personal outlook on the market.
Experience is far more important though, but sadly many spread betters new to the game stand little chance because their bet sizes are too large to begin with. This means that many lose a significant portion of their account (over 50%) before they can accumulate the necessary experience needed to be profitable.
So get smart, start small, expect to lose money while you find your footing and then use these experiences to draw up a long-term profitable game plan.
This is a guest article by Andy Richardson who writes at length and in more detail on spread betting and guaranteed stop losses via the website www.Financial-Spread-Betting.com