In one of my previous posts, I have shown how investors can hedge their portfolios and be better prepared for the potential market decline. In brief, the main purpose of hedging is to reduce investment risk and lock in profits by taking an offsetting position in a second instrument, such as options and futures, or by selling-short. While this sounds pretty intuitive and easy to do, in fact, the technique can be hard to implement without having an extensive investment knowledge, especially in derivatives.
The market adage says “Cut your losses and let your profits run.” In this post, I would like to share a few effective yet highly simple ways investors can utilize to protect their hard-earned profits and avoid catastrophic losses. No matter if you are a novice or an experienced investor, the below-mentioned methods are easy to implement, and unlike the hedging do not require a high level of investment sophistication. Moreover, even if you are a value investor and tend to hold positions for years while adding to them during setbacks, avoiding big losses and protecting your profits should be one of your top priorities as well.
Before I dive into the methods, you need to know what stop and limit orders are. As a quick refresher, a stop-loss order is an order that aims to limit one’s losses or protect existing profits by selling or closing the position when a specified price was touched. A limit order is an order to buy or sell a security on a specified or better price. While there are many variations of both orders, I will refer to stop-market and simple limits orders in this article.
One more thing I’d like to mention. When it comes to investing, the most important thing all investors should focus on is preserving their wealth. And by that I mean keeping losses under strict control. As I will show in my future posts, if you remain negligence to your losses hoping that things will work out on its own, you risk not only wasting a lot of time to breakeven, but also ruin your account. Imagine those who bought QQQ ETF on the peak of the dotcom bubble. It took them more than 15 years just to breakeven. An even worse example, Enron investors, who lost everything. Should investors apply simple protective measure, the ending result would have been completely different.
Methods to Avoid Big Losses and Protect Your Account
There are basically three key methods investor can use to avoid big losses and protect their accounts: fixed percentage, fixed dollar, and price-based stop losses.
- Fixed Percentage Stop Loss. This is the most simple and perhaps the most effective method to protect an account from huge losses. It is completely aligned with investor’s preferences and risk tolerance. Prior to opening a position, the investor determines a maximum percentage loss of an account value he is willing to accept, and then places a stop-market order right after the position was opened. The most usual percentage value is 10% for short- and mid-term investors and about 20-25% for long-term investors.
- Fixed Dollar Stop Loss. With this protective stop, the investor decides in advance what is the maximum dollar amount s/he is willing to lose and then places a stop-market order right after the position was opened. Again, this method is completely aligned with investor’s preferences and risk tolerance.
- Price-based Stop Loss. This method assumes finding an important price level which investor thinks should not be breached. As an example, many investors prefer to place a stop loss on the lowest price over the last 52 weeks. Once the price is breached, the position automatically closes. The main issue with this method is that if you buy a security after a strong uptrend that has been for a while, then your stop loss price may be too far away from the current price. Should the market reverse, the potential loss can be high.
Profit Taking Methods
I am sure you’ve seen and been multiple times in a situation when a highly profitable investment turned out to be a loser due to a market correction, negative corporate returns, or weak earnings in just a matter of days, if not minutes. Another market adage says, “The market takes the stairs up and the elevator down.” By implementing tactics below, I will show how to you can jump off the elevator right before it is going to go down and protect your profits.
- Fixed Percentage Profit Target. The investor decides in advance what percentage profit of the account s/he would like to make and places a limit order to sell the position when the target is reached. The method is very intuitive and easy to implement. However, it is usually based on emotions and market guessing. For example, a fearful investor may place a target that is too close to the current price and miss the rest of the growth if the market continues to grow. On the contrary, a greedy investor may set an unrealistic target and wait excessively long for the market to reach it.
- Fixed Dollar Profit Target. Absolutely the same as the previous one, except one decides how much in dollars s/he would like to earn and then places a limited order.
- Trailing Stop. This is a widely used method among investors because unlike previous two it allows for participation in market growth. The main idea is to set a predetermined percentage profit target level upon which a trailing feature of the stop activates. For example, the investor decides in advance what the percentage profit target he would like to earn (let’s assume 25%), but he also would like to have an opportunity to remain invested while market is rising and not to lose more than 30% should the price reverse.
- Trend Breakout. There are a few ways to determine the current market trend. Some people prefer to draw trendlines while others to use indicators. The most common trending indicator is the 200-day simple moving average. As with the trailing stop described above, the main idea for the investor is to remain in the market for as long as the trend lasts. Once the trend is broken, there is a chance for a market reversal and at this point, it might better to take the profit off.
- Price-based Trailing Stop. This type of protective stop also gives investor an opportunity to participate in market growth for as long as the trend remains intact. Once a specified price level is broken, a protective stop is triggered and the profit is realized. Unlike price-based stop loss, where the stop loss is always fixed, the exit price of this stop always adjusts upwards, thus locking more and more in potential profit. In the example below, I have added a price-based trailing stop that is based on the lowest price over the last 52 days.
- Volatility-based Trailing Stop. This type of protective stop is usually used by active traders rather than investors and requires basic understanding of volatility. However, I have been seeing more and more investors, especially short- and mid-term, incorporating volatility into their investing arsenal and profit protection methodology. The main idea behind a volatility stop is to adjust exit price in accordance with prevailing market volatility. If volatility were high then the protective stop would be placed further away from the current price in order to avoid whipsaws. On the contrary, if volatility were low then protective stop would be placed closer to the current price, hence locking in more profit.
Of course, none of the above methods is perfect. The main area of concern is that the position can be closed too early or the market can reverse right after you took off the profit. If this happens, one has to be willing to re-open a position again but only if the initial prerequisites are still valid. Otherwise, investors should focus on new opportunities.
Besides that, many value-based investors argue that using stops only hurts and triggers unnecessary actions and commissions. They insist that a simple buy-and-hold approach works better. I would say that buy-and-hold is indeed a valid approach but only if you portfolio is well diversified and is composed primarily of index funds. However, if you try to pick stocks on your own then buy-and-hold may be both bad and good, depending on your abilities to choose the right ones.
One final thought. Each investment decision should take into account your risk tolerance, investment horizon, and age. If you think you can tolerate a 50%+ decline that we saw in 2007 and then wait more than 5 years just to breakeven, then buy-and-hold again may be a valid approach. Otherwise, utilizing stops both for protecting your profits and avoiding large losses may not be that a bad idea.