Stoploss.......Theory of Failure.

[ducati998]

Jo,

Well I will be eager to read the article. I can't imagine entering a position without understanding and limiting the risk. Stops are the traditional way for traders to handle that. Ducati says he has another way to manage risk, - (perhaps its hedging, selling covered options and using the premium to buy an option opposite your contract position, or some other less traditional method). I willing to listen.

Derivatives definitely have a place within the risk management universe, however, they tend to be in "addition" to the underlying concept I am proposing.............( not that I originally conceived it however. )

cheers d998

 

[roguetrader]

Ok a quetion asked on another thread whicjh may have been inappropriate within that thread so I will rephrase and ask it as a general question.
As a FA trader evaluating a company for a trade, is it not possible by analysing all the fundamentals to arrive at a price level that the company share price should not fall below. A price at which to fall below would indicate that something was wrong, that was not showing up in the information available. And as such why would it not be appropriate to have a stoploss around this level?

 

[SOCRATES]

The answer is no.

 

[jimmy1jag]

Ok a quetion asked on another thread whicjh may have been inappropriate within that thread so I will rephrase and ask it as a general question.
As a FA trader evaluating a company for a trade, is it not possible by analysing all the fundamentals to arrive at a price level that the company share price should not fall below. A price at which to fall below would indicate that something was wrong, that was not showing up in the information available. And as such why would it not be appropriate to have a stoploss around this level?

I remember doing a price per share calculation exercise in the finance part of a course I did at business school several years ago. The calculated (theoretical) price (based on the financials) and the actual market price were a country mile apart.

Don't ask for figures cos I no longer have the notes and I'm not doing the exercise again

In my view and experience, wise investors already have their options for an exit strategy (to cover all eventualities) thought out before they commit. Those that don't suffer!

 

[LION63]

ABC has a share price of 500p and based on FA fair value is at 700p based on assets, cash and business prospects. I now have to decide if the current price represents good value or not or if a price of 400p would be a more realistic entry point. The problem with this is very simple, if I believe 400p is a better entry point how could I arrive at a conclusion that 500p is good value and the shares will be fairly valued at 700p?

 

[ducati998]

Rogue

As a FA trader evaluating a company for a trade, is it not possible by analysing all the fundamentals to arrive at a price level that the company share price should not fall below. A price at which to fall below would indicate that something was wrong, that was not showing up in the information available. And as such why would it not be appropriate to have a stoploss around this level?

The simple answer is no.
The accurate answer is that when you calculate a fundamental analysis, you are analyzing the BUSINESS.

The MARKET PRICE allows you to buy a share of the Business at $XYZ.
Market prices, as such are random and irrational.
The business may be sound, profitable, and creditworthy, but the Market price suggest imminent collapse.

As a value investor, it is my job to assess the Business, and exploit the anomally of the aberrant market price, eventually, as whatever caused the market to panic passes, so the price will correct itself.

cheers d998

 

[SOCRATES]

Rogue



Market prices, as such are random and irrational.


cheers d998

Another Gem.

 

[SOCRATES]

ABC has a share price of 500p and based on FA fair value is at 700p based on assets, cash and business prospects. I now have to decide if the current price represents good value or not or if a price of 400p would be a more realistic entry point. The problem with this is very simple, if I believe 400p is a better entry point how could I arrive at a conclusion that 500p is good value and the shares will be fairly valued at 700p?

This is value investing. Shrewd value assesment as the rights to an income, is the principle applied here, is is not Sir ?

 

[SOCRATES]

I remember doing a price per share calculation exercise in the finance part of a course I did at business school several years ago. The calculated (theoretical) price (based on the financials) and the actual market price were a country mile apart.

Don't ask for figures cos I no longer have the notes and I'm not doing the exercise again

In my view and experience, wise investors already have their options for an exit strategy (to cover all eventualities) thought out before they commit. Those that don't suffer!

I am not surprised at all.

An exit strategy is just as imporant, if not moreso, than an enrty strategy.

 

[LION63]

Socrates,

You are spot on, it is value investing. As market participants we can use all sorts of terminology to dress things up but dividends and capital gains all amount to the same thing - Income. The sole purpose of buying share is to obtain this income and once one has determined what the potential income flow is likely to be from what should be a reasonable investment what is the point of hedging ones bets by placing a stop loss?

Would that in itself not imply that one has a lousy judgement or to be more exact a very poor way of analysing investments which the market has shown time and again to be incorrect (hence the requirement of the stops in the first place).

 

[SOCRATES]

Socrates,

You are spot on, it is value investing. As market participants we can use all sorts of terminology to dress things up but dividends and capital gains all amount to the same thing - Income. The sole purpose of buying share is to obtain this income and once one has determined what the potential income flow is likely to be from what should be a reasonable investment what is the point of hedging ones bets by placing a stop loss?

Would that in itself not imply that one has a lousy judgement or to be more exact a very poor way of analysing investments which the market has shown time and again to be incorrect (hence the requirement of the stops in the first place).

No, it is a different way of looking at a vehicle capable of absorbing a sum of money for it to return a decent divi based on solid and reliable parameters. The gyrations in the market price I will concede are a different consideration altogether when viewed from this angle.

But a stop, whether real or implied is always a wise precaution in any event.

 

[LION63]

Accepted that a stop real or implied is a wise precaution and I very much doubt that anyone would enter 20 trades committing 5% of their capital to each one and watch the whole lot disappear down a whole over a period of time. I do not think anyone here would advocate allowing such a situation to unfold as far fetched as it might seem or sound but in the event of a severe melt down it could happen. In that kind of situation, the said trader would definitely look to salvage something from the wreckage unless he/she is a descendant of Nero. Would I be right in saying that a stop loss has been executed?

I actually believe that this thread is split into two camps - The pro and anti stop loss. Those that are against using stops in the main are saying that it should not be part of the method as so many traders use them because it in effect means that the method does not stand up under scrutiny. It should be more like a worst case scenario mechanism which is used/activated maybe once per 100 trades or so.

 

[SOCRATES]

I forgot to add to my previous post above and offer this as a footnote:~

It would be a shame to have to do all the work to find a good investment and to secure a holding based on value investement criteria only to be thwarted by the vagaries of the supply demand functions that potentially could bring down its market price, either specifically or as part of a general market move.

For this reason, and this reason alone, once for example the price has begun to lift, so that at least the dealing costs (both the buying and the selling costs) are covered, it would be a wise and prudent precaution to take to protect profits with a stoploss, in order at least not to erode or negate the progress of the excercise.

Insertion of stops cost nothing but are a very useful protection no one should neglect, under any circumstances whatsoever, whether trading or investing, or even speculating, for that matter.

 

[LION63]

Socrates,

Now you are talking my language. I would not be able to live with myself if a trade that had been showing a profit of say 12% reversed over a period of time and became a loser. I could only justify it if it was an investment and even then I would be quite irate.

Using a stop loss (actual or mental) to protect profits is something most traders would be well advised to use bt that is different from those that use them to trade positions and curtail insignificant losses.

I suppose one of the things that tends to be overlooked is that fundamental traders by nature have a higher pain threshold than technical traders and this will further explain why they are unlikely to employ stop losses willy nilly.

 

[SOCRATES]

Accepted that a stop real or implied is a wise precaution and I very much doubt that anyone would enter 20 trades committing 5% of their capital to each one and watch the whole lot disappear down a whole over a period of time. I do not think anyone here would advocate allowing such a situation to unfold as far fetched as it might seem or sound but in the event of a severe melt down it could happen. In that kind of situation, the said trader would definitely look to salvage something from the wreckage unless he/she is a descendant of Nero. Would I be right in saying that a stop loss has been executed?

I actually believe that this thread is split into two camps - The pro and anti stop loss. Those that are against using stops in the main are saying that it should not be part of the method as so many traders use them because it in effect means that the method does not stand up under scrutiny. It should be more like a worst case scenario mechanism which is used/activated maybe once per 100 trades or so.

It is in large measure because the great majority do not properly understand the reasons why stoplosses are so important. They tend to view stoplosses from a flawed viewpoint. This is incorrect. They serve to safeguard capital.

Of course for someone who does not really know what he is doing stoplosses would be viewed negatively. But they are a boon and a godsend to the efficient, and that in itself, is a curious paradox.

 

[SOCRATES]

Socrates,

Now you are talking my language. I would not be able to live with myself if a trade that had been showing a profit of say 12% reversed over a period of time and became a loser. I could only justify it if it was an investment and even then I would be quite irate.

Using a stop loss (actual or mental) to protect profits is something most traders would be well advised to use bt that is different from those that use them to trade positions and curtail insignificant losses.

I suppose one of the things that tends to be overlooked is that fundamental traders by nature have a higher pain threshold than technical traders and this will further explain why they are unlikely to employ stop losses willy nilly.

Yes LION, but the underlying principles are the same, the greatest significant difference is the use of time, that's all. In my previous post I mention a curious paradox.

This curious paradox is curious because efficient traders are secure in the knowledge that on balance they will get it right many many more times than they get it wrong. For this reason, butressed by this confidence, stop loss provisions are seen as a form of insurance, and ont a bugbear and a nuisance and an unnecessary cost, but the opposite.

You could say that the really efficient traders and investors and speculators do not really need stoplosses whereas the inefficient or the learners are i n dire need of them, yet they resist and argue and so on.

 

[roguetrader]

Socrates,

You are spot on, it is value investing. As market participants we can use all sorts of terminology to dress things up but dividends and capital gains all amount to the same thing - Income. The sole purpose of buying share is to obtain this income and once one has determined what the potential income flow is likely to be from what should be a reasonable investment what is the point of hedging ones bets by placing a stop loss?

Would that in itself not imply that one has a lousy judgement or to be more exact a very poor way of analysing investments which the market has shown time and again to be incorrect (hence the requirement of the stops in the first place).

Because unfortunately in the world we live people lie, not all the facts are the facts and the people who are not in the know, ie the small investor will be the last to know. Ones judgement may be absolutely spot on with all the facts available, but perhaps the facts available do not tell the whole story, or no-one who knew how to read the facts would get burned. Therefore no-one who knew how to read the facts would have been harmed by Enron. Now obviously Enron is an extreme example, and not really the issue here, the point I use that particular stock for is to illustrate that information is never complete. What I am trying to get at is that surely within the FA concept stocks must revolve somewhere around fair value, there must be a point where a stock falls so far below fair value that one would be led to believe that other people know something you don't.

 

[roguetrader]

I suppose one of the things that tends to be overlooked is that fundamental traders by nature have a higher pain threshold than technical traders and this will further explain why they are unlikely to employ stop losses willy nilly.

One of the unfortunate side affects of a high pain threshold is that pain is a warning to take action, before further pain, and more importantly damage are incurred. Those with an unusually high pain threshold, commonly sustain more damage before they succumb to the pain

 

[LION63]

Roguetrader,

Kindly remember that the following was written before you made the last two posts. Does this address the points you were making?

In 1985 I built a small portfolio and it became big enough for me to cash in some of it for a deposit on a house and buy a car. The residual balance then multiplied a few times and I started dreaming about buying a bigger house with cash and no borrowings. As the months went by the portfolio got bigger and bigger and by mid 1987 I was almost there. In the Summer I needed to go on holiday so I decided to cash some of it in and place the cash i the bank. I returned in early October and the value had decreased a bit but it was no cause for alarm as the shares were growth stocks, high yielders and had solid business models (no go go crap for te Lion); so I decided to sit it out.

Then one morning I woke up and the trees had all be blown down, broken glass all over the place etc. Nothing too drastic, cleaned up a bit of the mess had breakfast and switched MarketEye on (that thing used to cost a fortune and the charges were per minute), my heart skipped a beat as all I could see was a sea of red. Well it was not a catastrophe as even losses of 30% still meant that most of the holdings were in profit and I could liquidate my positions, bank the cash and go away on another holiday.

What did I just say?

Where were my market stops placed with my brokers? Where were my mental stops lodged in that coconut I called a brain? THEY DID NOT EXIST and the rest is history.

 

[roguetrader]

When a rescue worker is trained one of the first lessons he/she is taught is personal safety first, it does not matter how brave or heroic you are if you become a casualty yourself you are of little or no use to the victim you set about saving.
A similar priority exists within the financial mmarkets, this is the preservation of capital, whilst a stoploss may incur you a loss of capital, it serves to preserve the bulk of your capital and saves you from becoming an incapactated victim yourself