Do YOU Use A Stop-Loss To Protect Your Investment Profits?

If You Don't You Should!

Learn how to use a stop-loss to 'run your profits' and 'cut your losses' for maximum profits!

Simply put, even the best investment in the world will lose it's appeal sooner or later. When that happens, or when another investment looks even more inviting and potentially profitable, a reallocation of capital involves selling up and moving on.

Of course, there is another side to this: capital protection. Either your investment has increased substantially and you do not want to lose the gains you have made, or, the price is falling and you want to protect the capital initially invested. Either scenario involves monitoring of your investment and making a sale when you start to become nervous.

The easiest way to protect your capital when making an investment in shares or funds of some sort is by using a 'stop-loss'.

Quite simply, a stop-loss is a mechanical way of triggering a sale. For example, if you buy shares at 100p and don't want to lose too much if they fall and you are / were wrong, setting a limit at which you sell is a useful solution. You might set that limit at 10% or 15%. That would mean should the shares fall to 90p or 85p, you automatically sell.

This has some good and bad features as a system. Firstly, it is difficult to apply to shares that are highly volatile. If the shares often move by 5% or more in a week and a stop-loss set too closely to the current price, it might force you to sell when you would rather not. In those circumstances, a limit of 20% or more may be more appropriate.

On the plus side, if you really do need to protect your capital at all costs, selling should the price move against you is a vital way of protecting yourself. Sure, you may guarantee to lose 10%, but if the price keeps on falling, you may have saved a lot of money indeed.

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However, it can be argued - and has by far more successful investors than your author - that should an investor be unwilling or unable to accept a period of lower prices, that they might not be ideally suited as owners of a company. Charlie Munger, Warren Buffett's partner at Berkshire Hathaway, has often suggested that an investor ought to be willing to see the value of a holding fall by 50% for some time and not be concerned. We are, after all, investors in an active business and not numbers of a sheet of paper.

Shares often rise or fall in a rather predictable way - when things are good and a company is growing and generating good profits, prices rise and rise. If however, things are bleak and losses are being made, the fall can last for months or years and massive amounts can be wiped from a company's value.

It therefore makes sense to try and benefit from this trend, this is why many people use a 'trailing stop-loss'. This is a more active track of share prices and performance and is designed to let you (and I'm quoting a very famous investment saying) 'run your profits and cut your losses'.

To use a trailing stop-loss, set a number of points or percentage below your current share price. This will be your minimum - the automatic trigger to sell if the price is breached.

However, should the share price rise, your stop-loss is moved upwards in the same ratio as the share price. Thus, your trigger will still be (for example) 15% below the current price, but that will be higher than it once was.

The further up a price goes, the farther the trigger is reset. This has the effect of locking in a majority of your profits. Should the price go into reverse, you sell at your new higher level, but if the price keeps rising and rising, you get to profit from those gains.

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Now obviously, if I have just explained the above in a few paragraphs, it is far to simple for fund managers (information here) and investment bankers to be following. They have complex computer programmes that calculate how a price has moved in relation to an index, a sector and the rest of a portfolio. Decisions are far more complex. This of course is for pro's that manage dozens of shares and not the likes of us that manage a few at a time. But for managing a few at a time, the above is a simple and effective method to lose much less and profit more in the market.

One very real problem for private investors trying to enforce their own stop loss policy is the potential for large intra-day price movements. Those of us that do not follow the movements of Wall Street professionally can return from a day at work to see that a piece of news has broken and our stop loss is history. I have personally had my own limits broken whilst on vacation with those previous prices never to be seen again!

For short-term trades it is possible to put an automated stop loss order in place with your broker, but for more normal long only investments this is less likely to be possible. Therefore, setting and enforcing your stop limit is down to you the investor and not a computer system.

If you want to really see it in action, the best thing I can suggest is to find a few sheets of graph paper, draw a graph and start following a share price each day. Add the stop-loss at, say, 10% below the current price and keep plotting the graph over a few weeks.

Every time the shares hit a new high, increase that stop-loss. If the share price stays the same or falls just plot an extra day without altering the stop-loss. Pretty soon, it will all become very clear and remarkably simple to operate.