Using Protective Stops To Limit Risk

If your portfolio went south over the last few months the chances are that you had a broker with a big firm who bought you mutual funds using a “buy and hold” strategy. That means in the long run stocks will make money, so do worry if they drop a bit. It’s stupid… and they do it because it is a lazyman’s strategy. On the other hand, if you got out of stocks and into cash sometime after June 11, 2008, the odds are that you or your broker bought stocks with a stop strategy. So, in my book that makes stops a good thing.

So what are stops? Well its a very simple idea… and let’s take the simplest case when you are expecting (or hoping) the value of the stocks to increase. In that case, a stop sets a minimum value to which you will allow the stock to fall before your automatically sell it. Fo,r example if you purchase a single share of stock for $100 and set a stop at $90, then you are saying that if the stock hits $90 it should be automatically sold. That means that you control your risk in purchasing the stock to 10%. You’re not actually risking the full $100.

The diagram at the right will give you the picture. The jagged line represents the value of a stock. Like any normal stock there are days on which the value goes up and other days on which the value goes down. You decide to purchase it when it has the value shown by the circle on the left and the horizontal line tagged Purchase. Using the stop strategy you immediately set a stop value to control your risk in purchasing the stock. Now, as the diagram shows, the trick is in finding the right value. Notice the line tagged Stop 2. If you set your stop at the value you would have lost money on the stock because it would have automatically sold at the point represented by the second circle from the right… and you would have lost (Purchase – Stop 2) dollars. On the other hand, look at the line tagged Stop 1. This value for the stop allowed the stock to take a normal downswing in values, but then rebound and continue higher. So, the real trick is to figure out what normal ups and normal downs are and set your initial stop value below the normal downs. There are different strategies for doing that based mainly on your investment philosophy. However, notice that the bigger swings a stock typically takes, the larger the risk to you… and, yes, that becomes one factor in evaluating which stocks to purchase at a given timYe.

You can’t just set a stop and then forget it. You need to check it routinely and adjust it… and one of the most simple strategies for adjusting it is that when the value of the stock goes up you raise the value of the stop, but when the value of the stock goes down you leave the stop alone. So, as the stock increases, the stop value goes up and your risk diminishes until finally you hit the “holy grail” and your stop value is greater than the purchase price. This is shown by the line tagged Stop 3, and when that happens you are guaranteed to make a profit on the stock. You no longer have any risk. The stock may continue to rise in value or, as in the diagram, it may fall. The beautiful thing is that when it falls it automatically sells at your guaranteed profit value. That’s shown in the diagram by the circle on the right. In the diagram, the profit on the stock was (Stop 3 – Purchase) dollars.

From this brief discussion, it should be obvious how stops can save you from catastrophic failures in stocks like we have seen in recent months. Don’t buy the line of baloney from your broker about buy and hold. Protective stops could have saved you the last 5 years in profits.

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