When using Stops is Not Appropriate

One of the first things a novice trader – whether spread bettor or otherwise – is taught, is that the use of stop losses is paramount. It is deemed to be the number one trading rule that you should obey before venturing into the markets. A rule that is founded upon very serious risk management principles. Prime example – if you let a loss run to 50% of the original purchase price then it requires a return of 100% to break back even – I know, unfair, eh?

The primary problem however with stops is the knowing just where to place them – if you place them too close to your entry level then you will likely be shaken out of a position before you even got started. Place it too far away and it will reduce the capacity for you to get your calls wrong, i.e. 10% stop losses with 6 trades consecutively wrong (it happens!) will put a decent sized hole in your account…

The purpose of this piece is not to suggest at what percentage level a stop should be placed – that of course is up to you and your individual risk parameters and trading style; intraday trading in currencies will, by necessity, require tight stops whereas “swing” trading will allow larger latitude. No, the idea behind this is to illustrate one prime trading strategy where a stop loss can actually be detrimental to your account.

Let me explain. We rewind a few years when I personally made a large sum spread betting in a company called ITM Power. I don’t say this to boast – far from it, as I got clobbered on some successive trades during 2011 (as did many) – but to illustrate precisely how the use of a stop would have changed my account profit profile dramatically over the years.

To simplify what I am about to explain: the basic premise is that when you are “position” building – that is adding to a trade (generally on weakness and ensuring that you do not exceed your individual position size limit of course), and most typically in a stock as opposed to an index or currency (although there are situations where this does not apply as I will relay below) – the use of a stop, if you have done your research, may not actually be appropriate.

In my own ITM situation, I began purchasing the stock during mid 2009 around the low teens and continued to add to the position right into the low 20s, reasoning that the cash backing (although being depleted) of 20 odd pence per share was a good safety net for me. During this period, an ex director was a perpetual seller of the shares, seemingly for his own personal reasons, and continued to hang over the share price. Meanwhile, new management were doing all the right things and putting the company back on a proper commercial footing.

During the ensuing 12 months into late 2010, the stock gyrated around and returned to the mid teens numerous times and so, on paper, creating a loss of around 25% on my original entry price – a level the trading “masters” would say you should not allow to accrue. Now, my point here is that I (a) had done my homework, (b) was comfortable with my position size and (c) was able to deal with the “draw downs”, and so what sense did it make to sell the stock as a reaction to another party who was selling?

Sometimes, when you are holding an equity position, and particularly on the purchasing side (as opposed to being short) where you are hoping to be in at a major bottom (prime example being certain of the gold mining stocks at the moment), what can happen if using the arbitrary stop level is that you can be forced out of the position only to see the shares then shoot higher – a typical characteristic of a major bottom actually. Of course that is immensely frustrating…

A recent academic study by Cabot Research revealed that where stop loss triggers at 20, 30 or 40% were in place and the proceeds redistributed across other holdings, investors would have done worse than holding onto the stocks. Reason? Unrealised short term losses tend to bounce back.

There may also be other reasons entirely detached from the investment basis of the stock that causes somebody to sell. Using a topical example again, there are suspicions at present that “Mr Sub Prime King” John Paulson is shortly going to be forced to sell either some of his gold ETF holding or his weighty positions in many of the mining companies he is invested in due to over exposure and consequent margin calls it is speculated he is under. If you happen to purchase some of these stocks at the current lowly valuations and a “whale” is forced to liquidate that creates a temporary spike lower, then why on earth should you follow the distressed/forced seller if arguably the valuation story has got even more attractive?

I must stress that this strategy is only really suitable for asset backed stocks with low and, ideally, no debt, i.e. where the probability if you are buying at a discount to NAV of around 50-70% of further material falls is low (absent outright fraud, of course, and which does happen now and gain). In fact, the scenario painted here is precisely what we are doing at the moment with selected Gold miners such as African Barrick and Avocet Mining where we personally believe the asset backing is materially greater than the current stock prices. If the shares fall a little further, then this increases the value to us, not diminishes, and so we reason that arbitrarily selling is a nonsense. Our approach is in fact akin to that which Warren Buffet takes with his investment and has its roots in value based investing.

The key in this strategy, you will no doubt have realised, is to ensure that the position size when buying into perceived major bottoms is not so large that it causes you a problem should the stock have a final, typically V shaped shakedown. You want to be there on the right side of the V and if you are adequately capitalised then you are sound of emotion – that is my mantra anyway!

As relayed in the introduction to this piece, this strategy can actually also apply to indices and currencies where the dislocation from fair value has reached material proportions and so the chances of a further sharp drop of a similar magnitude is slim. Although we have hindsight on our side now, the nadirs of 2009 were prime examples – you didn’t want to buy the FTSE at 3800 with a stop at 3700 only to see it rally hundreds of points in days… We also think we are in a similar situation with the British pound against the Australian dollar now – after a near 50% depreciation over the last 4 years, the chances of another fall of this magnitude are, in our opinion, almost non-existent and so building a position with manageable trade sizes is a preferable way to capture the hoped-for upside as opposed to sticking a stop at say 2% away from the current value. Again, subject to appropriate capital management re trade sizing.

I purposely have not mentioned that this strategy be used on the short side, i.e. when selling a stock short that you perceive as being overvalued. If you think about the primary backing of this approach, it is all about the “safety margin” – making sure that the chances of further dramatic falls are slight. With a short position in a stock, currency or index, one thing I have learnt over the years is that overvaluation can go way, way, way beyond what you would ever believe possible and stops most definitely should be adhered to when short. The Nasdaq bubble of 1999/2000 is where I learnt this the hard way, but that is a story for another day…

Article reproduced from the April 2013 edition of Spread Betting eMagazine