As traders and DIY investors we are tasked with skilling ourselves in an environment that is full of known and un-known variables. To help prevent the unknown variables from continuing to take capital from our portfolios, it is necessary to implement a strategy that exits trades based on either a technical exit signal or a financial stop loss.

Setting a financial stop loss is a Risk Management action as it provides an exit strategy for the active investor. Financial Stop Losses are generic Risk Management techniques and are NOT employed by SPA3 because SPA3 uses technical exit signals. Financial stop losses are explained here to put SPA3 Risk Management and technical exit signals into context.

There are four types of stop loss that can be set:

• Initial Stop Loss (ISL) is the price at which the trade will be exited if the trade immediately goes in the opposite direction to what the trader’s analysis showed.

• Breakeven Stop Loss (BSL) is the price at which the trade can be exited if the trade starts off profitably and then turns in the opposite direction.

• Trailing Stop Loss (TSL) is a profit protection technique that is calculated as the price moves in the direction shown by the trader’s analysis. It is used to lock in profits when the price undergoes a reversal from the profitable position.

• Technical Stop Loss is an exit signal that is based on price action, a pattern or a technical indicator.

It is also possible to set profit stops which take profits into a trend but these are not discussed in the blog posting.

The ISL and BSL are set before taking a position in the market. The TSL is calculated (and re-calculated) while a position is still open. All three of these Stop Losses are defined as Financial Stop Losses as the exit price is calculated purely from the financial constraints that the active investor imposes on their open position. These are not related in any way to the market price action of the stock.

There are a number of well-known methods that can be used to calculate the actual stop loss:

• The most well known Stop Loss rules are the 1%, 2% or 5% rules, based on the total value of the portfolio. Which % is used should largely be determined by the term of the investment and risk profile of the investor. A short-term trader could opt for a 1% rule whilst a 5% rule would be suicidal for the short-term trader, whilst a 1% rule for the medium to long-term active investor could prove a bit restrictive.

The 2% rule will be used in the examples to illustrate the generic use of Financial Stop Losses. This does not mean that 2% works best for medium-term active investment. In fact, therein lies one of the major problems of Financial Stop Loss calculation; stocks have different characteristics and move in different ways in the short and medium and long term. Applying a specific % Stop Loss rule across the board for all stocks can be too sweeping and is NOT linked to the behavior of a particular stock price in any way.

Furthermore, it is unknown how a standard % per trade would relate to overall portfolio drawdown for a particular methodology unless research is conducted.

For the purpose of illustration, a portfolio capital of $50,000 is used. This means that a maximum of $1,000 (i.e. 2% of $50,000) will be risked on any trade, that is, the maximum amount of capital that can be lost in any single trade is $1,000, including brokerage.

The ISL and the TSL are calculated using the 2% rule. (The position size can also be calculated using the 2% rule but that is a money management technique which reverses the calculation but also requires the trader in pick a price stop level.)

Assume that an entry signal occurs for a stockpriced at $5.50 and that $7,500 of the total portfolio capital will be committed to the trade. 1359 shares are purchased for $7,475.50 and brokerage of $25 is paid, for a total cost of $7,499.50 ($7475 / $5.50, rounded down)

In order to limit risk at $1000 of total trading capital, the ISL is set at $4.78 ($7,474.50) - $1,000 + $25 divided by 1359, assuming exit brokerage of $25).

The BSL is calculated by adding the buy and sell brokerage onto the $7,500, i.e. $7,550 and dividing by the number of shares purchased. The BSL is, therefore, $5.56.

The TSL will only come into play when the trade is in profit territory. Assume that the share price rises to $7.00. Assets on hand are now $9,513. The TSL would be calculated as $6.29 ($9513 - $1,000 + $25 = $8,538 divided by 1359). If this price is reached the stock is sold. A portfolio manager would dynamically recalculate the 2% and TSL on a daily basis.

• Another method often used for Stop Loss calculation is deciding a percentage of the trade capital to be risked for an individual trade. For example, if the capital committed to a particular trade is $10,000 then the ISL could be $1,000, i.e. 10% of the trade capital. The actual ISL exit price would equate to the $1000. Usually, a range of 5% - 10% is used with this method for medium-term active investment depending on the amount of capital committed to the trade.

The problem associated with this method of Stop Loss calculation for medium-term trading of equities is the same as the 1%, 2% and 5% rules for ISL, BSL and TSL – it is not linked to the market price action of the particular characteristics of individual stocks.

By setting these Stop Losses it is known in advance when to exit the trade. Psychologically, this is very important as it assists in making the exit more clinical otherwise it will leave the trader open to influence from emotions, ego and outside ’noise’. The size of loss trades will be consistent and largest loss trades, which are portfolio killers, can be avoided.

However, the major problem with Financial Stop Losses is that investors can get stopped out of the trade whose trend is still up, hence registering lots of small loss trades instead of a profitable trades. This results from the following:

• Financial Stop Losses do not recognise that all shares do not behave in the same way. Having a fixed trailing stop loss regime for all shares will, in many cases, stop profits by stopping the investor out of the trade before the trend has ended or even started.

• Financial Stop Losses are based on the individual investor’s financial constraints, not on market price action.

Financial Stop Loss settings, therefore, can counteract the whole basis of successful active investment: "Cut your losses and let your profits run", which is all about following trends. If you exit the trend before it has ended, or even started, based on a financial stop loss, a lot of big profit trades will be missed.

SPA3 only uses technical exit signals (unambiguous and mechanical) based on market price action through the use of volatility based exits and momentum indicator exits. Over a large sample of trades, the average loss per trade is around 1% of portfolio value. This is not a targeted risk per trade percentage by design, merely an outcome of the SPA3 entry and exit mechanisms interacting with market price action.

A universal ‘formula’ exists when trading and investing that needs to be understood and positioned in the trader’s psyche to continue to be successful on an ongoing basis. Anybody can place a few profitable trades, randomness will take care of that. But to continue to be successful on an ongoing basis requires more than the consequence of randomness.

Being successful on an ongoing basis means running a portfolio (let’s assume equities – other instruments can be traded) that continues to rise at a faster rate than the market accumulation indices (or, more practically, managed funds) whilst experiencing acceptable (to you) drawdowns (troughs or valleys) in your portfolio along the journey.

Depending on your perception of investing, you will have a different view of what it takes to continue to be successful in the market. Whatever it is, it is sure to be encompassed in the following ‘trading formula’.

The ‘trading formula’ comprises the following:–

• doing the necessary preparation through research,
• an edge with a positive mathematical expectancy,
• well defined trading processes that are part of an overall trading plan,
• continuing to engage according to your processes regardless of market conditions,
• trusting your processes and your edge,
• executing with confidence,
• resisting “noise” outside your processes,
• overcoming fear and euphoria,
• overcoming hesitation, indecision and reservation,
• becoming empathetic with the market,
• transitioning your processes and your thinking into habits so that they become a natural part of who you are,
• becoming consistent and objective in your decision making
  (which are the ultimate aim and are the by-product of your processes and how you think).

Along the way you may need to deploy certain techniques, tools and skills to achieve the various parts of the trading formula, such as discipline, technical analysis, fundamental analysis, money management principles, risk management principles, research capabilities, mental drills, physical drills, execution drills.

Discipline is not an end but a technique to use to achieve an end. Some already have the capability to be disciplined, some learn it and some don’t. Once a particular end is achieved, discipline is no longer required because the end becomes a part of who you are and is executed as a matter of habit. Habits don’t require discipline. Transitioning from the ‘new knowledge’ stage to the habit stage is a process that few people complete. Existing habits get in the way and they give up or they chop and change between different ‘knowledges’ and hence remain inconsistent. These are two of the biggest obstacles to individuals going to the next level in any endeavour that they take on, not just trading and investing.

Notice that knowledge is NOT a mandatory part of the trading formula to succeed in this trading caper although it could be argued that it fits under ‘research’. Most individuals that fail have sufficient knowledge to succeed, it is that they don’t transition the knowledge that they have into a set of processes that are consistent and objective nor do they achieve the necessary mindset for trading. They continuously vary their processes on a whim without the necessary preparation and research. Waiting for newer or better knowledge is not the answer. Working on the parts of the ‘trading formula’ is the answer and transitioning from knowing what to do, to doing what you know.

One of our core aims at ShareFinder is to continue to provide active investors with the tools, training and ongoing coaching necessary to enable active investors to trade and invest according to this trading formula and hence achieve a sustained profit advantage in the market.

Marcus Padley, of stockbroking firm Paterson Securities, in his regular column in The Age wrote a knowledgeable piece that every active and passive investor should read. The title of the article “Where brokers dare, we should tread carefully” is a two part editorial in which Marcus conveys the 10 lessons learnt by Mr Harry Hindsight.

What’s unusual in this article and several others over the past week is the ground breaking mind shift from those within the industry. Finally the unspoken truths of the financial industry are becoming exposed, highlighting the fact that the industry needs a reset.

To quote Marcus: “… the finance industry is a marketing machine… ” and “… there is uncertainty about just whose purpose half the advisory world is attempting to serve”. I whole heartedly support these statements. I have said and written similar statements in the past.

Marcus goes on to state “buy and hold is dead” (refer to my past journal posting “Death of the Buy and Hold investor”) and “… we need mechanisms outside the ramblings of the brain to protect equity investments. Unemotional triggers. We need systems and we play in markets without them at our peril”.

This is why I am so passionate about mechanical active investment and believe that the road to successful active investment is found through the mechanical way. In terms of probabilities those that follow a system that is derived from market price action have a much higher probability of success.

http://business.theage.com.au/business/where-brokers-dare-we-should-tread-carefully-20090501-aq8x.html

http://business.smh.com.au/business/faith-in-the-creed-of-buy-and-hold-cost-us-10-years-20090508-ay4i.html

I have to question what is suddenly causing this rational discussion from inside the industry? A crushing bear market? Is that all it took? How fickle? For many years I felt somewhat alone in voicing my opinions about the weaknesses of the financial advisor and broking industry.

The second article written by Deirdre Macken, “Money: why we can’t handle it” conveys how we are psychologically crippled for investment, whether it is stock market, real-estate or general finance related. Deirdre points out, “More polite people will describe these dim decisions as ‘bounded rationality’ or ‘inherent biases’ but whatever you call them, science is proving the brain is not well equipped for modern finance and people who don’t realise how their humanity undermines their rationality are vulnerable to making poor decisions”. These phrases, which have been locked away in the annals of psychology books for decades (Kahneman & Tversky completed their initial research in the late 70’s), are now appearing in the daily financial press!

http://afr.com/home/viewer.aspx?EDP://20090509000031124451&section=perspective&title=Money+why+we+can't+handle+it

I can only agree with this article adding that human beings are woefully flawed, particularly when it comes to managing portfolios in the financial markets (btw, fund managers fall into the category of human beings too!).

I simply believe that the highest probability way of achieving success in the market (for an individual investor or professional money manager) is by deploying a mechanical trading system, based on price action, that has a well researched and well defined edge. The rigour, rules, structure and processes of a mechanical approach are required to overcome the human flaws and industry flaws discussed in these articles. The rules of the system need to cover market and stock timing, risk management and position sizing. Don’t leave home without one!!

There is natural rhythm in the universe. Day follows night, the tide ebbs in and out, the seasons change from autumn to winter to spring to summer and the fauna and flora all follow their natural processes during the season changes. Squirrels store acorns, birds and whales migrate, bears and snakes hibernate, trees lose their leaves and plants flower all according to their natural rhythm. No thinking takes place here, the fauna and flora on our planet follow their instinctive natural processes that are hard wired (programmed) into their anatomy.

Human beings also have a natural rhythm on a day to day, month to month, year to year and decade to decade basis. However, we also have a brain and a heart that is capable of thinking and causing feelings. And this is where we can and do differ from the fauna and flora. We break our natural rhythm by feeling anger, frustration, betrayal, revenge, anxiety, uncertainty, hate, doubt and fear. Sure, in the heat of the moment our logical thinking minds will justify as right why we feel these negative feelings.

For example, anger triggers hormones that create tension and anxiety in the body and these hormones then shut down parts of the brain to enable dealing with the anger-created state of tension. The parts of the brain that are shut down also cause clouded judgment and poor decision making. This leads to steps in your process not being followed correctly and even not seeing things that are typically obvious to you when you are in your natural rhythm. This is one of the causes of ‘perceptual blindness’. In short, anger makes you stupid as does hate, fear, doubt, revenge and frustration which manifests in the form of mistakes and errors that you wouldn’t otherwise make.

When you feel any of these negative feelings you will be incapable of executing actions that you would normally execute “blindfolded” when in your natural rhythm and this will affect your trading processes and the outcomes of your trades. Furthermore, feelings tend to spiral in the direction that they are going in, negatively or positively until an opposite force is brought to bear on them.

To ensure that you are able to stop negatively spiraling emotions and turn them around, you need to understand and acknowledge what they can do to you, and then train yourself to recognise your negative emotional state and define a process to turn them around to create a confident state of mind in the heat of the moment.

This process may be different for different people so you may need to discover what works for you. However, we all have the same chemicals in our bodies and mechanisms in our minds so there is a good chance that similar processes will work for most people. Experiment with breathing patterns and repeating affirmations through auto-suggestion that slow your body down and start generating chemical reactions that counter those generated by the negative feelings mentioned above and start positive spiraling feelings. In later issues we will deal with methods and drills. I can assure you that, amongst other things, your trading outcomes will improve.