Stop Loss as an Integral Part of Trading
Purpose of the Paper:
The recommendation aims to introduce the most common and accepted ways of incorporating
a stop loss strategy. The abridged paper is designed to be a simple version of how to use the
tool. It will offer three methods of controlling losses through the stop loss method.
Disclaimer:
It is important to keep in mind that every strategy will have benefits and shortages. The stop
loss works well as a risk-management tool reducing severe losses. However it will on occasions
give false signals i.e. it will trigger a stop loss call which will then be followed by a price move in
the opposite direction. This may cause one to exit their position at bottom prices whilst
incurring avoidable transaction costs (commission cost mainly). One should always keep this in
mind. A better way of approaching this would be to take the performance of a significant sized
sample of portfolios. Out of 100 trades does the stop loss strategy does more benefit than
harm? It should. The three methods illustrated here are:
1. Stop Loss Using a Singe Moving Average
2. Stop Loss Using Swing Lows
3. Stop Loss Using Trend-Lines
1. Stop Loss Using a Single Moving Average:
The simplest method to implement this strategy involves a stop loss being triggered
when prices penetrate the moving average downwards. The most common practice
involves the stop loss being triggered when prices close below the moving average. This
is the confirmation for the trigger –Prices closing below the moving average.
Another common practice which is a bit more on the conservative side involves the stop
loss being triggered only when prices close below the moving average for two consecutive
days.
Figure 1A. Shows a stop loss being triggered as soon as the price closes below the moving
average. However the security price moved upwards the following day, making this a
short term whipsaw (Whipsaw describes the movement of a security when, at a particular
time, the security's price is moving in one direction but then quickly pivots to move in the
opposite direction). In this instance using the more conservative approach of selling off
the position once prices closed below the moving average for two consecutive days would
have yielded a better result.
Figure 1A. Illustrating the shortages of the Stop-Loss Strategy.
The Following Figure 1B. Shows another stop loss being triggered once the price closes below
the moving average. In this instance the strategy would have saved the trader a downside price
move of over 27%.
Figure 1B: Shows a stop loss being triggered
The two conditions for triggering a stop loss includes:
i.
ii.
Selling off when the security price closes below the moving average.
Selling off when the security prices close below the moving average for two
consecutive days.
Both offer merits and problems. The first one is more prone to whipsaws whilst the second one
is slow to react to big price changes. The trader must decide which one fits his style of trading.
Other Factors that need to be considered when choosing a moving average:
A. Types:
Exponential Moving Average (EMA): is a moving average that gives more weight to recent price
data. Thus the latest price action will have more of an impact on the moving average direction.
Single Moving Average (SMA): is a moving average that gives equal weight to all the price data.
Hence its direction is NOT particularly influenced by the recent price action.
Recommended: Exponential Moving Average since it is more sensitive to recent price action.
Figure 1C: (As can be seen below the EMA depicted by the green line responds to the direction
of the price action faster than the SMA in the red line)
Figure 1C: Illustrating the differences between a EMA and SMA
B. Defining the Time Frame:
The time frame has to supplement one’s time horizon i.e. if one’s trading horizon is short
term it makes more sense to use the 40 day EMA instead of the 200 day EMA. However
when using short term EMA’s there will be a lot of noise (signals indicating a false directional
change) however it will react to changes in the market more quickly. Long term EMA’s have
lower noise but are more reliable, it will however react much slower to changes in direction.
Figure 1D: As we can see below the Shorter 40 Day EMA (Green Line) has more change in
direction, with 6 changes shown within the selected time frame, the directional changes are
highlighted with the Green Arrows. The Longer 200 Day EMA (Red Line) has only two
changes within the selected time frame which is highlighted as well with the Red Arrows.
Figure 1D: Differences between the timeframe of a moving average.
C. Adjusting the Time Frame to the Stock’s Characteristics:
It might be profitable to select a moving average that has historically done well in signaling
significant price changes in a stock. In the example below a sell call is signaled once the price
as shown with the candle sticks fall below the selected moving average shown in the GREEN
LINE.
As we can see below in Figure 1E, the selected moving average timeframe has done a fairly
good job in assessing significant turning points. The stock found support thrice at the
moving average as depicted by the green arrows. This reassures the trader that the moving
average has historically done well when acting as a support.
The Blue oval in between highlights another sell call which was triggered once the moving
average was penetrated with a price fall. However the fall in price from the stop loss point
had a maximum decline of 6.30% until it rebounded and moved higher. Since the fall was
short, the moving average sell signal proved to be a weak but still useful one.
The Red arrow on the far right of the graph shows a stop loss signal that was again triggered
once the price fell below the moving average. In this instance the maximum decline from
the stop loss point was 15.29% which was a significant one. If stop loss was triggered then, it
certainly would have saved a lot of money.
Figure 1E: Well Adjusted Time Frame.
With the hopes of painting a clearer picture, the moving average timeframe used below in
Figure IF does a relatively poor job historically. The highlighted segments show three cases
where stop loss was triggered when prices fell through the moving average. However price
did not fall off too far and the stock moved back up. Since the time frame adjustment was
not too good for this one, it resulted in avoidable trading cost.
Figure 1F: Historically ill-adjusted time frame.
Conclusion:
As we can see the moving average can be used as a stop loss trigger point. It offers a distinct
and easy method to introduce into one’s trading strategy. However it offers limited
application for prices that are far off the moving average. When prices are significantly
away from the moving average (usually accompanied by an abrupt price move or when the
security is in a strong trend), its application becomes limited. One way to combat the
problem is to re-adjust the time frame. The use of a lower time frame will allow the moving
average to get closer to the price, making it a more effective tool.
2. Stop Loss using a Swing Low:
Swing low is a term used in technical analysis that refers to the troughs (lowest point) reached by a
security's price or an indicator during a given period of time, usually less than 20 trading periods (not
fixed so it is customizable according to style). A swing low is thus created when a low is lower than any
other surrounding prices in a given period of time. It is the lowest price (low not closing price) point of
the time interval. A daily price interval is most commonly used.
The recommended approach is to use the most distinct price low of the current price pattern. A simple
and synthesized approach would include the three examples below
Figure 2A: Swing Low Example Using a Mid Term and a Long Term Time Frame:
Figure 2A: Shows the swing lows using two time frames. For the larger one which is captured within the
green rectangle we see the swing low in the green arrow near the bottom center of the figure. The
shorter time frame is captured in the purple rectangle- the arrow identifies the swing low according to
that particular time frame. When prices close below these swing points the stop loss is triggered and
should subsequently be sold off. Again whipsaws are a possibility.
3. Stop Loss Using Trend-Lines
Trend Lines
Trend lines can be used to identify and confirm trends. A trend line connects at least 2 price points on a
chart and is usually extended forward to identify sloped areas of support and resistance. Lines with a
positive slope that support price action show that net-demand is increasing. As long as the price action
stays above this line, we have a bullish trend. (Source: https://www.tradingview.com/ideas/trendline/)
Figure 3A: Bullish Trend line using Support:
As we can see in figure 3A, the trend lines are drawn by drawing a line connecting at least two support
points. The more support points they touch, the stronger the trend line. They do not have to touch the
lows exactly and as long as they are close to them, the trend line can be used. Once the price closes
below the trend line the stop loss is triggered. This method will give a lot of signals leading to more
whipsaws especially in a volatile stock or market. It is better used in a strong uptrend, where there is
already an established trend through some fundamental change like severe earnings growth.