How to protect your gains with stop-losses

With the market now recovering more than half of its losses, it’s time to remember how little has really changed.

Many of the same people who feared another fall in the market was on the horizon are now beginning to fear that they have been left behind.

Which in itself can be a bad sign!

And there is still inflation. Gasoline prices are still high. There are still major problems in the supply chains and there is still a war in Ukraine.

The market has rallied strongly even as the folks on the bottom busily sold off, comparing it to the GFC and 1987 crashes and chart comparisons predicting another leg down.

How to protect yourself

Now that it’s made a strong recovery, it’s probably worth thinking about how to protect yourself.

It’s not certain that these negative theories will hold true, but it is certain that there will be more sell-offs in the future, and as such it’s important to have a plan — especially for smaller-cap companies.

Lest we offend any of the smaller companies, we’ll use Fortescue Metals Group (ASX:FMG) for this exercise – as it’s big enough to handle a few retail stop-loss orders!

It’s also important to remember that technical analysis doesn’t work as well on smaller companies, as their volumes are often smaller and they’re often event-driven — rather than herd- or trend-driven.

But Fortescue often fluctuates as wildly as a small-cap stock, so it’s a perfect example.

There are a number of indicators of a “top” formation, but no single sign is sufficient. Sometimes the RSI overshoots, sometimes an intraday candle shows sellers taking over again, and as we discussed earlier, sometimes the moving average cross works as well.

Stop loss volatility indicator

But in this article, we will discuss stop-loss and the volatility indicator that can help you position your stop-loss orders – the Average True Range (ATR).

The problem with stop losses is that the market is inherently volatile. And the more volatile it is, the bumpier the ride, so don’t get knocked out too easily — only to find the stock recovering quickly.

I once heard someone refer to it as “playing with a yo-yo while walking up (or down!) the stairs,” and that made some sense.

The ATR gives no indication of price development, it only calculates the degree of price volatility.

So the lower the volatility, the lower the ATR and the tighter your stop loss should be. The higher it is, and the opposite is true.

In the chart above, you will notice that volatility peaked on the lows (panic) and bottomed on the highs (discomfort?).

More importantly, it shows that you should have a tighter stop if people aren’t panicking because markets tend to go up, all else being equal.

People are optimistic by nature and are looking for a return on their money, but they can easily panic.

Double the ATR value

The conventional wisdom when using ATR is that you should set your stop loss at twice the ATR value.

So, as in this Fortescue chart (15 Aug 2022), your stop loss should be:

58.75 cx 2 = $1.175 below last price. That means about $18.57.

Low enough that you won’t be blown away by daily swings, but close enough to protect you from a bigger sell-off.

Other factors to consider

According to Travis Clark, Managing Director of Marketech Online Trading, there are a few other factors to consider when using stop losses.

“When people use stop losses, there is a ‘trigger price’ and an ‘order price’. The trigger places the order, so in this case you could set your trigger at $18.57.”

“But if you also place your order at $18.57 you may miss the market, especially if it reopens significantly lower after a bad day in the offshore markets,” explained Mr. Clark.

“The market can skip your order, gap down, and you will get stuck in the queue.”

He said the company recommends people set the order price a little lower if it’s falling fast and set up an “alert” at the same price as the trigger so your phone pings when the stock hits your stop-loss price and you can jump in quickly and change it if needed.

“We set up the platform for exactly these scenarios. So if you look at the image I provided you can see that the green line is the cost basis at $19.14, the trigger at $18.57 with the blue dotted alarm line at the same price and the order at 18, $19.”

“When the trigger hits, a notification also goes off, then I can quickly check the order on my phone to make sure everything went well. And if not, I can just click and drag the line on the chart down to change it,” noted Mr Clark.

“There are a few other things about stop-loss orders that people need to remember. Once the order has been triggered, it still needs to be checked for potential market rule violations. So don’t enter the order too much lower than the trigger, otherwise it will be blocked, and if you list the stock for sale when the market is higher, the stop loss trigger will not cancel that higher order, so the automated Order router thinks you have no shares to sell.

One of the only caveats to offering trades with a minimum of $5 is that Marketech traders must have stock on their HIN to sell it and cash to buy it lest it hit the market – maybe use a trigger sell above price to also take profits, so it will either sell you higher or lower, whichever comes first.

And please do not invest in thinly traded stocks!”