Setting Stop Losses and Falling Markets

Your investments should never end up in freefall!
Your investments should never end up in freefall!

The average investor – and I mean the kind who wouldn’t bother to read this blog – never thinks about an exit strategy. He or she buys a stock because it looks promising, with plans to hold it until retirement or some other life event requires a large chunk of money. This “buy and hold” strategy is perfectly reasonable, except for the times that stock prices go down. Which happens a lot!

In fact, the average investor is more likely to sell too early, and miss out on profit. But sell too late, hoping the stock price goes back up. This is a bad, bad, BAD idea. An example:

Let’s say you finally succumbed to all the talk about people getting rich off the stock market, and in May 2007 you bought an S&P 500 index fund (an “ETF” fund designed to mimic the movements of the S&P 500 index) at around $151. By October, the crap hits the fan and the market starts a long, painful plummet to depths never before seen. All the while, you hope and pray it’ll turn around sometime. But this plummet is a deep one. Did I mention a painful one? It’s “the Great Recession”. At the depth of the plunge in March 2009, the SPY was valued around $69 per share. That’s a loss of 54%! The market did eventually go back up of course, but it wasn’t until January 2013 that the price of the SPY fund equaled your hypothetical investment of $151.

So what, hey at least it went back up, right? NO! That’s almost six years where your money was worse than useless. Your cash just sat around, not working, drinking beer and staying out late at night, contributing nothing toward your retirement. That six years might make the difference between which golf club you join in your retirement.

The horizontal line indicates your hypothetical $151 investment.
The horizontal line indicates your hypothetical $151 investment.

Imagine if, back in that fateful May of 2007, you said to yourself “Self, here’s what we’re going to do. The market’s still going to go up. Way up! To heights never before seen or imagined. I can feel it in my soul. But…just in case…if it ever falls from its peak, we’ll sell. Maybe 10% down. What do you think? Self? Now don’t cry, it won’t ever happen, it’s just an emergency ‘stop loss’ in case the unthinkable happens…”

The market peaked soon after your investment at around $155, and then fell and fell. But you summoned up the courage, and in January when it fell to below 10% of that, you sold.

Ok so you lost about $11 per share. And then you just sat and waited.

Then, shortly after the market hit bottom, it was back up by 10%. You had a little internal conversation again, and decided to get back into the market. Your 11$/share loss was soon erased and then some! So when January 2013 rolls around, you’ve made a gain of $81/per share. Sure you lost 7% on your initial investment. But you then just about doubled your investment on the way back up. 100% profit! You would have just been breaking even if you hadn’t gotten out of the market.

And keep in mind this was a fund that spreads the risk over many stocks. You might have gotten lucky and found a stock that didn’t fall quite as much. Or you might have picked a stock that simply went out of business, turning your investment into only a good story to tell your grandkids.

EVERY investor should have an exit strategy for when things don’t go as planned. My wife once said to me “you don’t believe in company X, so that’s why you want to sell.” I replied “no I do believe in that company and I think they’ll do great in the long term! But their stock is way down from the highs and I want the opportunity to make money on them twice!”

Since these are shares she bought, we are still negotiating this little issue….

Next post: how to actually set those stops, at least from this one guy’s perspective.

 

Where Are the Customers’ Yachts?

yachts

While many books about trading and the stock market quickly become irrelevant, certain aspects of the markets are timeless. I’ve been going through my local library’s bookshelves, looking for books that might provide some insight. Most are technical in nature, but I’m currently reading Where Are the Customers’ Yachts? (or A Good Hard Look a Wall Street) by Fred Schwed Jr.

It was originally published in 1940, and has been reprinted several times since then. It’s a light-hearted, satirical and amusing roast of Wall Street and the players involved. Brokers, retail investors, bankers, chartists, short-sellers…no one avoids scrutiny. Given the book’s age, it’s amazing how much of it is still deadly accurate today. So if you want a short read and a good chuckle, I recommend it.

A link to the book for your convenience (no affiliation).

Swing Trading System using Bollinger Bands

bollinger-band-tk-profit-old
The black arrow is the signal day, and the green arrow is the trade day (at open).

 

As promised, here is the system I was using that initially got me into the EXAM (ExamWorks) trade, making me over 10% in about 30 trading days, after commissions. But before I go any further…

DON’T USE THIS SYSTEM.

Why? Because the stop loss and profit target values are highly suspect. In fact, I modified these after I initially made the trade, because they were unreasonable. I’ll explain that a little further down.

I’ve always been fascinated with Bollinger Bands. It’s amazing how the price bars just flow between them, bouncing back and forth and never quite escaping. This of course is all backwards, because the bands are there BECAUSE of the price bars, not the other way around. Cause and effect is an important thing to keep straight when trading stocks.

That said, there are some recurring patterns that intrigue me. I’ve noticed that after the lows have hugged the lower Bollinger Band for awhile, they usually head in the other direction. Then, if all goes well, they smack up against the high Bollinger Band for awhile, like helium balloons on the ceiling at New Years Eve. Rinse, and repeat.

The system I came up with that got me into the EXAM trade was this:

• All trades occur at the open of the following day after the signal. This allows me to actually work for a living and then make my trading decisions after the market is closed, and put my orders in overnight for the opening bell.

• Market must be in an uptrend, as determined by the S&P 500 (SPY) having its 65-day moving average be above its 195-day moving average. No point in trying this in a bear market. *

• Close price must be above $15 and average 10-day volume must be above 100,000.

• I used a Bollinger Band of 20 periods and 2 standard deviations, based on the closing price. (I’ve since changed that…)

• My screening software looks for four bars that have their lows below the lower Bollinger Band, followed by a fifth (most recent) bar with a low above the Bollinger Band. The last low below the Bollinger Band must be less than the first low below the Bollinger Band. Just to be clear, if the signal day is day 5, then day 4’s low must be below day 1’s low. This little plummet can have other bars before it with lows below the band, but it’s the four below and then one above scenario that we’re looking for. Check the lead graphic as an example. NOTE: I’ve since tested and found that four bars below works better. But I didn’t use that for this trade, so you’ll only see three bars.

• Buy at the open of the day that follows the signal day (the bar with the low above the band).

• Now here’s where it gets particularly dicey. Set a stop loss at 15% and a take-profit amount at 21% above what you paid for it (the “tradeprice”). In other words, if the price closes either below .85*tradeprice or above 1.21*tradeprice, then sell that puppy the following day at open.

When I did all my backtesting with ProRealTime, I could only test a single stock at a time. So I would enter all the data into a spreadsheet and add up the totals. I would compare various variations to each other, and pick the one that made the most money. From a sheer time/fatigue standpoint, I could really only do this for 30-40 stocks at a time. PRT doesn’t allow you to test on a portfolio-wide basis over a whole universe of stocks.

So the reason this is dicey is not because it won’t make money…it tested pretty well in that regard. The problem is the drawdown! The other problem is the amount of time your stock might just be sitting around, drifting one way or the other, taking forever to hit either the stop or the profit target.

I picked 15% as a stop loss because I’d read somewhere that 15% was a good number. I’ve also heard lots of other numbers since then. The problem with a fixed percentage either as a stop loss or a profit target is that some stocks aren’t volatile enough to get to either point very quickly. Which really misses the point of a swing trade.

I’ve since run this scenario through AmiBroker, which allows me to test across a big batch of thousands of stocks. When I tested with data from 1/1/2000 to 12/27/2014, I got a profit gain of 169.41%, bringing a hypothetical investment of $30,000 to $80,821.94. That was reasonably decent compared to some other systems I’ve worked up. The problem, as mentioned before, is the drawdown.

1. Portfolio Equity

Look at those big dips as the market fell apart in 2002 and 2007-2008. Interestingly, this system is kind of flat in 2014, even though the market has been on a upward tear. The sign of things to come?

Note also the straight lines at the end of 2002 and between 2008-2009. This is where the filter for the S&P 500 kicked in, keeping me from trading in a bear market. Otherwise losses would have been much larger.

2. Underwater EquityThis hypothetical portfolio traded a maximum of 5 positions at a time. Look at those painful drawdowns in 2003 and 2008…a maximum 24% of the entire portfolio! Hurts my eyes to look at.

So how to fix this? One way would be to use stop loss and profit targets that are tailored to the innate volatility of a particular stock. One way is to use Average True Range as a basis for stops and targets. This tailors the exits to what the stock has the potential for, rather than some one-size-fits-all percentage. I’ll talk about that in a future post.

By the way, most of the portfolio-related stuff I’ve learned from Llewelyn James, either through his book or directly from him. Including the reasons for why 15% is a dumb number to blindly pick. This particular swing system (DON’T USE IT!) is all my creation though.

Disclaimer: I think I mentioned enough times that you shouldn’t use this system. Not just because trading in general is risky, but because this system isn’t particularly good. If you’re into CAR/MDD** ratios, it has an embarrassingly low value of 0.17 It is however the basis for other ideas that appear to work better. Oh and I should mention that once I realized a 15/21% stop/profit was f-ing cray-cray, I changed it to a 3 x ATR/4 x ATR stop/profit instead…which got me 10% profit.

Now I’m going to go sit and watch my leveraged short-oil ETF as it goes through the roof. 🙂 Oil dipped below $50 today, and I’m cheering for it to go lower.

-Matt

* BTW I’ve since started using a 40-day vs 120-day comparison for bear markets…a little faster to respond to a downturn, but also will likely create a little more choppiness and false starts at the end of a downturn.

** Compounded annual return divided by the maximum drawdown. This rewards profit but also penalizes drawdown. Keeps your account from hemorrhaging money while you’re waiting for the next big win.