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Risk Management

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Zaxon

The voice of reason
Joined
5 August 2011
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With the recent, sharp drop in the share market, I thought it would be a good time to revisit risk management. Specifically, I'm looking from a medium time horizon: holding stocks for a few months.

Break-even Stops

Traders have the concept of break-even stops. They're designed to make you feel good, because should you hit that stop, you haven't lost any money. But I'm wondering with medium term investing, do BE stops really make as much sense?

Consider this: $100k into share XYZ. After a few months (or years), the share has had a nice run up, and is now worth $150k. You have in place a BE stop. Good! You can't lose any money! But if it hits that stop, you've lost 50 thousand dollars: 50% of your wealth (in that stock). So my question is whether the concept of BE stops is even useful in longer term investing? (Hopefully you'd have other stops in place anyway.)

Whole Portfolio Risk

Secondly, let's assume, because you're a longer term investor, you use a trailing loss of 20% (for the simple purpose of this discussion). You allocate 5% of your portfolio per stock. 20% of 5% = 1%. That's 1% maximum loss (of your portfolio) per stock. Sounds safe! But then the market crashes, and all your shares lose 20% together. Suddenly 1% estimated risk becomes 20% actual risk. The question is, is there a way of mitigating this? I don't believe there is (for the average, vanilla investor), but I'm interested to hear your thoughts.
 
Fully agree with you on the first point pure feel good, but number wise, there is no meaning in break even stop: how long, break even exit after a week or even month: great, but after 4 years...
Purely psychological
My experience with stop loss is that when you really need then for a magnitude event aka market crash or black swan, your stop loss get pulverized and you are back on your computer rushing to limit the damages.my 2c only, but great in normal trading etc
 
My long term super holdings are still within the systems parameters
Total down 6.6% ( not happy about that omen ).
Even with my long term holdings I initially have a break even stop as part of the input parameters.

The rest is part of the system

I personally don’t think this market action is an outlier.
 
If your hold time is a few months then you are likely rotating in and out of stocks on a regular basis.

Fuzzy time frame trader or investor?

This means a stop loss point (tested?) based 1st on market conditions then maybe on value, profit or loss.

If your hold time is years then you have entered (I am making assumptions) based on price, valuation or growth with the option to top up during major dips (thinking Craft like simplistic), selling due to changes to the issues around the stock not market conditions.

Risk management must compliment be integral to the over all strategy (obviously) not a add on.

Risk can be manged by stop loss (driven by market conditions), buying value (big leeway due to upside long term), buying a market leader or maybe buying income or any method that provides a buffer to the down side.

Then there is a hedge position, issue is when do you take a position to hedge against losses protect profits(trader territory perhaps).
My own approach is to look at this in and around the 1st lower low (depending on price action) and happy to be stopped out at break even-ish.
 
I think you nail it from my perspective.

I want to own a stock to capture the current & future business earnings. Provided the underlying business/assets aren't impaired than price can go up & down all day.
 
I've seen a lot of "gapping" in the last few days, where the stock will open below your stop-loss, or as you say, just blow straight past it: your stop-loss triggers, but the price has already gone much lower by then.

I think the only solution is to manually chase it. Otherwise you've become a buy-and-holder, in which case you wouldn't have had the stop-loss to begin with.
 
tech/a said:
Even with my long term holdings I initially have a break even stop as part of the input parameters.
Click to expand...
You can certainly have one initially. And that's not a bad idea. But as the months roll on and you've seen substantial growth, then I think the idea of "I haven't really lost anything if I break even" becomes less
true.

tech/a said:
I personally don’t think this market action is an outlier.
Click to expand...
I see drops in the market as a great chance to test the protections you have in place, and see how they're really working. I know you have strong ideas on risk management. Can you scale your same trading risk management to longer term?
 
Zaxon said:
I've seen a lot of "gapping" in the last few days, where the stock will open below your stop-loss, or as you say, just blow straight past it: your stop-loss triggers, but the price has already gone much lower by then
Click to expand...

My view is to always consider that whilst the market as a whole will not go zero, any individual stock can in practice lose most or all of its value if things go badly wrong.

For something like a supermarket chain it's pretty unlikely that they'd go to zero in a hurry but for something like an airline or mining company, well consider the likely impact on the value of the shares if the company had a major incident (plane crash, mine blows up, whatever) yesterday. Market down heavily + major incident = price is going to blow straight past your stops and probably by a substantial amount.

Stops are fine as a concept but no guarantee you're actually getting out at that price. Personally I view them as being a bit like planning an outdoor event based on a location's long term weather records. Just because statistically it's unlikely to rain on any given day in January is no guarantee that it won't rain on the day of your event. Choosing to hold it in Summer has reduced your risk but not eliminated it - worst case you could still end up with a flood. Plan accordingly.
 
IFocus said:
If your hold time is a few months then you are likely rotating in and out of stocks on a regular basis.
Fuzzy time frame trader or investor?
Click to expand...
I'd call that a "position trader". Part investor, and part trader, and has a mindset borrowing from both camps.
Hedging is particularly relevant. And as you mentioned it, I thought this is the perfect opportunity to jump into a deeper discussion on hedging. So let's break down the options, basing it on the context of this thread: holding positions for a few months.

Buying Puts

You can buy puts against your shares. All the research I've seen says that buying puts is like insurance: it will save you in a black swan event, but you'll never get out of it (in claims) as much as you'll pay into in premiums over the long run. So over time, buying puts as a hedge (rolling puts) causes you to significantly underperform the market.

Diversifying

I think this is quite important: if you only hold 5 stocks you've possibly seen massive pain in the last few days. If you hold 200 (so probably an index fund), then it hasn't been so bad. But diversifying within stocks only protects you from idiosyncratic (individual share) risk, not whole market risk. And we know the whole market drops by 50% every 20 years (or so).

You could diversify out to other asset classes, such as commodities and bonds. I see conflicting points here. If you're spooked by volatility, then holding a mix of stocks/bonds/commodities is probably the right thing to do. The counter argument is that unless you're retired (or close to it), diversifying out to other classes will leave you to underperform the market in the long run. Imagine a 50:50 (stocks:bonds) portfolio. Much more stable, but will also dramatically underperform a 100% stock portfolio over 20/30 years.

Let's look at our options beyond hedging.

Asset Timing

One advantage of a medium term trader is the ability to swap assets. You can switch heavily into gold/bonds/property, or heavily into a specific sector (shares) that is outperforming the rest of the market. It has the advantage of not being dragged down by holding lesser performing assets (like bonds) 100% of the time. But there's the timing risk. If you don't time it right, you may end up underperforming a simpler buy-and-hold approach.

Stop-losses and Technical Exits

I think any price-based (technical) strategy benefits from protecting yourself against a falling stock. I'll include stop-losses and exits based on hitting moving averages or resistant levels, etc here: they're all trigger when there's a significant price drop.

If you don't use price protection, then you're probably a buyer-and-holder or a value investor (greedily buying on the dips).

Stop-losses allow you to take a modest loss to avoid the potential of a bigger loss. And if your stop is gapped over or blown through (which definitely happens), I think you need to jump into the market and sell out anyway. Otherwise, don't have a stop-loss if you're not prepared to enforce it.

The downside of stops is when the share that you've just sold, suddenly turns around and fully recovers its price. I'd still argue a stop is important, because for every share that recovers, there's probably another three that continued to drop, and your stop-loss saved you from holding those.

The other downside is 'death by a thousand losses'. Your stop-losses work as intended, but in a volatile market, you're frequently whipped out, and you have a string of modest losses. Those losses add up. One remedy to this is setting looser stops. But if a share drops significantly, looser stops cost you a lot more. You could have stopped out of that falling share much earlier. That's why I don't think there's ever a "perfect" stop.
 
CBerg said:
I want to own a stock to capture the current & future business earnings. Provided the underlying business/assets aren't impaired than price can go up & down all day.
Click to expand...
While a perfectly valid position, as the context of this thread is that of a medium horizon, I'll raise a counterpoint.

Let's use CSL as an example. It's had an amazing run for years, but in the last 12 months, it has basically gone sideways. There's hundreds of shares that have outperformed CSL of late and you could be holding one of those. A medium term trader has the option of getting off "stalled" shares, and following the ones which are actively increasing in price. (Whether that's a better strategy than buying and holding quality stocks in the long run, depends on many factors).
 
Smurf1976 said:
My view is to always consider that whilst the market as a whole will not go zero, any individual stock can in practice lose most or all of its value if things go badly wrong.
Click to expand...
Very true. Which speaks to diversifying to a number of stocks, rather than concentrating on just a few.
I like that analogy a lot! Well worded. Stops tip the balance of you being protected in your favour, but are never a guarantee that any individual stock won't cause you a significant loss.
 
Agree with the enforcement of a Stop Loss. Whether it's a SL placed in the market or a mental SL based on the tolerance for maximum you are prepared to lose, once that threshold is breached it should be executed even at a much worse case scenario than anticipated due to gaps/slippage/wide spread etc.

Zaxon, mate when you get a chance could you please start a thread on market sectors and how it affects stock selection. I think due to thought provoking wording you use, there is a lot of interest in the question threads you initiate. So word it how you like it to get maximum discussion happening and I am sure all the ASF members will benefit including myself.

To help you formulate the question, here is the background: Certain sectors run hotter than others at any given time in the markets e.g. now it might be Gold stocks, a little while back it was biotech's and before that it was banks and financial stocks including BNPL type fintech stocks. We don't have to know the exact reason, it may be due to funds management rotating from sector to sector or some economic reason such as flight to safety or yield but we know that this is undeniably a characteristic of the market. What will be good to find and discuss is how do the experienced/professional investors/traders find the hot stocks in the hot sectors ? Is there a recipe/scan to use or is it through doing a lot of stock research like I do and realising that certain stocks are getting attention e.g. it could even be very specific niche segment of the market e.g. Cannabis stocks within Biotech space or Lithium stocks within Mining space etc.

Finally why is this important ? Well let's not kid ourselves, we are all here to make a bit of dough right. Few members may be far too well off and only visit to discuss politics and health . As for the rest of us, we want to know which sectors are moving right? If we have ten stocks from different sectors that have the same setups based on TA/FA which ones would you choose? I know from experience if you pick the few in the cold sectors they'll go sideways or even lose you money but if picked from the leading (hot) sectors they have a much better chance of galloping along to higher ground. Without having the insider knowledge of where the fund managers and institutions are targeting, how do we target the winning sectors ? Let's get the discussion started on another successful Zaxon thread.
 

I'll just add my half a cent that I think that's a very good point and one that's widely overlooked.
 
Smurf1976 said:
I'll just add my half a cent that I think that's a very good point and one that's widely overlooked.
Click to expand...
Thanks for the support. It's these kind of overlooked areas that can give us an edge in the markets than just churning the account buying and selling any odd basket of stocks. We have to find the potential winners amongst the ordinary with any tools/techniques we can find.
 

In the past I've used a sector approach. That is, choose a sector(s) based on in my case FA and then just buy either the top 10 stocks in that sector or, if there aren't 10, everyone who's a significant player without any real emphasis on individual stocks as such.

In that case I was taking a very narrow definition of it. Eg "airlines" not "transport" or "supermarkets" not "retail". etc.

The potential would seem to be to combine strategies. Pick a sector based on FA or TA and then carefully pick stocks within that sector(s) based on FA or TA.

Potentially that could combine different approaches. Eg pick the sector(s) based on FA and the stocks based on TA. Or pick the sector(s) based on TA and then do FA to find who's got the best business within the sector. Etc.
 
So far nobody has addressed my original question #2. If every share only puts as risk 1% of your capital, but then if the entire market drops you're actually risking 20% (or insert figure here), is there a way around that, without being overly cautious and hurting your opportunity of future returns?

I believe short term traders do something like this.
1. Buy share ABC with a risk of 1% of capital
2. (If that share hits a stop-loss, rinse and repeat with another share)
3. Should ABC go above break even, consider you now have no money at risk.
4. You can now buy share DEF at 1% risk, while holding share ABC "risk free", and still consider yourself to be at 1% risk in total.

While that type of thinking can work for shorter term traders, I'm not sure if that makes sense if we're talking about holding shares for months (medium term), and you've had a 50% run up on one of your shares. Because you're then talking about the % drop from your current portfolio value, rather than your original entry value. Still, I'm wondering if position traders can learn something from short term traders about risk management.
 
Zax
This would depend on how long you have been in the market and if all
of your holdings blew out below your stop.
If you'd just opened 20 positions then perhaps this could happen.

But for a long traded portfolio your going to get hit x % on possibly both open profit and
perhaps some stops.

The earlier we can recognize a sustained move down then the less chance we have of
depleting large swathes of money.
Sometimes you'll be right other times wrong.

I personally think that Systematic Traders need to have in place something that recognizes
a change in data that is big enough to affect long long term results V those tested.
But it will become part of the data which your method will be constructed from.
This is why systems which are not continually learning form data often eventually fail.

Discretionary ---well you are at your own discretion! You'll be right and wrong.

I don't think you can avoid some loss---but you maybe able to diminish maximum
loss in this case 20%
 
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