By Dr. Van Tharp
Knowing when you’re going to exit a trade is the only way to determine how much you’re really risking in any given trade or investment. If you don’t know when you’re getting out, then in effect you’re risking 100% of your money ~ Mel
Van says that risk is the amount of money you are WILLING TO LOSE if you are wrong about the market. So his definition of risk is how much you’ll lose per unit of your investment (i.e., share of stock or number of futures contracts) if you are wrong about the position that you have taken. This is called the initial Risk or (R) for short.
One of the key principles for both trading and investing success is to always have an exit point when you enter a position. Trading without a predetermined exit point is like driving across town and not stopping for red lights–you might get away with it a few times but sooner or later something nasty will happen.
In fact, the exit point that you have when you enter into a position is the whole basis for determining your risk, R, and the R-multiples (i.e., risk /reward ratios) of your profits and losses. Your exit point can be either a percentage, in points or in dollar terms.
For example, William O’Neil says that when you buy a stock, you should get out when it loses 7-8%. Another trader proposes a philosophy of getting out of a stock when it moves 1-2 points against you.
Tell me more about Stops
A stop is basically a preplanned exit. Van says that having stops prevents disaster even though this strongly goes against the grain of the long-term buy and hold philosophy. When the price hits your stop point, you exit the market. A trailing stop, basically adjusts that stop when the market moves in your favor, thus giving you a profit-taking exit as well.For example, if you buy a stock at $30, and have a 25% stop, then you would exit the trade if the price drops 25% to $22.50. In a trailing stop example: You buy the same stock at $30 (with the initial stop at $22.50) but if the stock moves up to $60, your 25% trailing stop would also move up with it and would be placed at 25% of $60, which is $45.In other words, you would get out of the trade if the stock turned and dropped to $45.00 but because you bought it at $30, you would have locked in half your profit or $15. The trailing stop, in other words, moves the exit point in your favor as the price moves in your favor. BUT you must never move it backwards. Thus, if your stock moves down from $60 to $50, you would still keep your exit at $45, 25% away from the high of $60. In Van’s opinion, this kind of stop is a safe form of buy-and-hold. You could be in a stock for a long time, but if something fundamental changes, it gets you out.
As an example, JDSU went from about $12 in February 1999 to a high of nearly $150 in 2000 (prices are adjusted for a number of share splits). A 25% stop would have kept you in the entire move. You would have been stopped out in April of 2000 at a substantial profit. However, if you had used a buy
-and-hold philosophy, the same stock hit a low of $1.58 in October 2002. You might never get back to breakeven (an 800% gain from current prices) in your lifetime, but the stop would have totally allowed you to avoid that fall. In addition, it would have gotten you out of stocks like Enron and WorldCom before any of them became headlines.
There are many reasons for using tighter stops and you will probably need to use them for a variety of different trading styles. We are simply suggesting 25% stops as a substitute for the “buy and hold” philosophy. We are not going to get any further into stops at this point because we want to get back to talking about risk. Just remember, you need to know when you are getting out of a position (your exit point or stop) to determine your risk.
Dr. Van Tharp