The following post was originally published on Make Money Your Way
Good morning! Today Troy continues with the investing for beginners series.
The last key component to trend following is risk management. Whenever you make an investment, you cannot only dream of how much profits you can make. There is always the possibility that you made the wrong investment decision. In such a case, what are you going to do? How are you going to protect your hard earned capital?
Plan B to the rescue! When you make any investment, you always need a risk management tactic. How are you going to prevent your losses from becoming bigger if the market moves against your investment? How are you going to keep your losses contained and keep the situation under control?
For trend followers, the answer is to typically use a stop loss.
A STOP LOSS
A stop loss is exactly what it sounds like – it stops your losses and prevents your losses from growing. How? When your investment loses a specific % (e.g. if the market moved against your position by 10%), the stop loss will automatically liquidate your investment position and limit your losses. That’s how your loss is “contained”.
Why are stop losses necessary for trend followers? Because investing is all about probabilities. “In this investment, what is the probability of the market moving in my favour? What is the probability of the market moving against my investment position?” Obviously, the smart investor only invests when the odds are in his or her favor. But what if the improbable situation happens and the market moves against the trend follower?
The trend follower will say that losses are a matter of fact – there’s nothing you can do about them. All you can do is invest when the odds are in your favor. When the odds are against you, all you can do is cut your losses using a stop loss and say “oh well. That’s life”.
So what does a stop loss look like? A stop loss is an order to automatically liquidate your position when your position reaches a X% loss. Here’s an example. Let’s assume I bought Apple stock (which is currently at $500 a share). If I create a “10% stop loss”, that means that my stop loss is at $450 a share. If the market falls below $450, my online broker will automatically liquidate my Apple stock at a 10% stop loss and prevent my loss from becoming bigger.
TREND FOLLOWERS TYPICALLY EMPLOY TIGHT STOP LOSSES
As an investor (and in this case, a trend follower), you can place your stop loss anywhere you want. You can place it far away from your entry price (e.g. 20% below your entry price), or you can place it very close to your entry price (e.g. 3% below your entry price).
HOW DO YOU DETERMINE WHERE TO PLACE YOUR STOP LOSS?
The answer to this question is totally up to your discretion. Placing a stop loss close to your entry price can be detrimental. Although it limits your losses to a smaller amount, it can also cut into your profits. What happens if your stop loss is only at 3%, the market falls 3%, and then it rallies 50%? You get stopped out with a 3% loss whereas you could have made a 47% profit!
Having a large stop loss can also be detrimental – you’ll lose more money (e.g. a 10% stop loss means more money will be loss vs. a 3% stop loss). However, a large stop loss also has its advantages. It avoids the problem mentioned above with close stop losses. If the market falls 3% but your stop loss is at 10%, you won’t get stopped out.
Personally, I don’t do a lot of trend following. But when I do, I typically use a 7% stop loss. That is just a matter of my personal comfort zone. 3% is too small, but 10% is too big.