By Teeka Tiwari
Stop-losses are essential to preserving your capital, and you should use them on every security -- stocks, options, Exchange-Traded Funds, etc. -- that you add to your portfolio. However, what's the best way to determine where to set your stop?
Oftentimes with options, many investors may find it easier, and more beneficial, to examine the underlying stocks or ETFs themselves to determine where to set their stop-losses.
Personally, I always set my option stops off of my stock stops. Once you determine where to set your stop on the underlying asset, you establish a solid framework for when it's the best time to exit your position ... and whether or not to enter the position in the first place.
Many of you might have seen the article below already, but for all the new Tycoon Report readers out there (welcome!) as well as everyone who is looking for a refresher on how to properly set sell stops on your stocks, today is a great time to learn about (or revisit) this very important topic.
Where Do You Start? With Your 'Stop'
When getting stopped out of a trade, we never want to lose more than 3% of our total equity.
Here is a quick example: Let's assume we have a $40,000 account; 3% of $40,000 is $1,200. So, if our stop is hit, our position size needs to be such that our cash loss is no greater than $1,200.
So, your actual position size is governed by the amount you are willing to lose.
Let's continue with our example. You have a $20 stock you want to buy, and you have a $40,000 account but you are not sure how many shares you should trade of this particular security.
The first thing you have to do is figure out your stop-loss point. Let’s assume that the stop-loss is at $17. To figure out the share amount, simply divide the amount you are willing to risk ($1,200) by the amount of points your stop-loss is from your entry price. The entry price is $20 and the stop loss is $17, so the difference between the two is $3. So, $1,200 (the amount we are willing to risk on any one trade) divided by 3 equals 400.
In this example, then, you can buy 400 shares and, if you get stopped out at $17, your loss will be no more than 3% of your total portfolio value.
To Change Your Stop-Loss, Adjust Your Position Size Accordingly
If you want to make your stop point larger, you must adjust the amount of shares you buy. Let's say you took another look at the stock's chart and decided that you wanted to have a stop-loss point of $15 instead of $17.
All you would do is take the difference between your entry price of $20 and your stop-loss price of $15 (which is $5) and divide that by $1,200 (3% of your portfolio value). This would give you a figure of 240, which means that, if you want to use a stop-loss of $15, the biggest position you could take -- and still be within the 3% rule -- is 240 shares.
This is what I mean when I say that our stop-loss point dictates our position size. You choose your stop-loss point, and your stop-loss point chooses your position size.
What Happens if You Get 'Stopped Out'?
The second part of this strategy has to do with position sizing after getting stopped out. I use a progressive system of investing, which means that, as I’m winning, I progressively increase my position size. When I'm losing, I progressively decrease my position size.
If I’m making several attempts to get long on a sector and I keep getting stopped out -- but I still believe the sector is ultimately going higher -- I do things a little bit differently.
After the first trade is stopped out, I reduce the position size of my next trade attempt by 25%. If that attempt ends in failure and I want to take a third attempt, I will decrease my initial position by another 25%.
If I want to take a fourth whack at the same trade, I’ll decrease my position size -- once again by another 25%.
NOTE: If I’m having several losing trades in a row, I institute this approach across all my new buys. Typically if I have three losers in a row on three different stocks, I start cutting my position size. This way, I’m trading at my smallest when I’m trading at my worst.
Too many people do the exact opposite; that is, they actually trade more and in bigger-size positions when they are losing. What they essentially end up doing is pyramiding their losses.
Too many people do the exact opposite; that is, they actually trade more and in bigger-size positions when they are losing. What they essentially end up doing is pyramiding their losses.
Here’s what it actually looks like. Let's assume we have a $40,000 account, and again 3% of $40,000 is $1,200. Let's further assume that the initial position is 400 shares of a $20 stock and each subsequent attempt to purchase the stock is done with a $3 stop-loss.
If I have four wrong trades at 3% per whack, I will lose 12% of my starting capital, or $4,800.
If I use my progressive approach of reducing my position size after every loss, I will own:
| 400 Shares @ $20 - $3 loss = -$1,200 |
| 300 Shares @ $20 - $3 loss = -$900 |
| 200 Shares @ $20 - $3 loss = -$600 |
| 100 Shares @ $20 - $3 loss= -$300 |
| Total Loss = $3,000 |
By progressively lowering each new losing trade, I reduce my losses from $4,800 to just $3,000 or a very manageable 7.5% loss.
The 25% reduction in trading size is always keyed off the initial position size. So, on each attempt, I am reducing my position size by an additional 25% of the original 400 shares, rather than 25% of 300, 25% of 200, and so forth.
I use this same approach in reverse when pyramiding into a winning position. On each successive new purchase, I increase my position size by 25% while always maintaining a stop-loss that I move higher with my position.
Remember, losing stocks won’t kill you in investing. Undisciplined position sizing, over-leveraging and trading without a stop-loss is what blows out most traders.
Nobody likes to lose money, but even in the best markets (and definitely in tricky markets like the one we're in now), your No. 1 goal is to live to trade another day. Losses are a fact of your trading life, but by limiting them with stop-losses and tailoring your positions to take as much risk off the table as possible, your discipline and consistency in adhering to the "3% rule" for your stocks will ultimately pay off in all the trades you make, including options trades!
