Are Your Investments Ready for 2016?

Looking forward into 2016, there will without doubt be further periods of volatility ahead — much like we saw in 2015. The important thing, though, is to approach the market with a good focus on what you want to achieve for that year.

While investors need to be careful, too much negativity can lead to missed opportunities. One way to start the entire year is to compile a list of shares you’d like to own. And…be patient. You only need to look over a price chart to see how far some shares can swing in any provided year.

I haven’t yet met anybody who can regularly pick a marketplace bottom, or a top for instance. So, if you pick an entry price, make sure you also have an exit price prior to placing your trade. That is, an end loss order.

To kick issues off in 2016, I’m going to run through some of the different ways that investors can manage their trades. By manage, I’m talking about risk management. So let’s check out some of these different stop loss methods now.

A review on risk management

First, a quick review on just what a stop loss is. A stop loss is a pre-determined point that once brought on, exits you out of a industry. You don’t sit there and mull it over. Nor is it something debate. Once it hits that level, then you’re out.

Though ordinarily a price level, you can also use additional points, like time, or a price to earnings (P/E) ratio, for example. A stop loss helps to manage your risk through setting out the maximum you’re prepared to lose on any given trade. However, in setting your stop loss, you needs to give your trade enough ‘room’ to move.

Now let’s look at some of the more popular strategies.

Fixed amount

One of the most common ways to set a stop loss is a straight proportion. For example, a trader might choose that they’ll put a stop loss level 10% below their entry cost. If they had $2,000 allocated to a trade, then they might exit the trade as soon as it drops $200 in worth.

However, you can see that 10% doesn’t give the trade much room to move. A decent correction is likely to knock you out of the trade. Determining what percentage to use often comes down to how long you plan to hold the industry for.

A long term investor (somebody that might hold for seven, eight or more years) might use the wider stop. Something like 25% or even 30%. Again, the idea is to provide the trade enough room to move while still giving you an exit point if the trade goes against you.

One thing to be aware is that this percentage is not an isolated number. It needs to be used in conjunction with the amount an investor allocates to any provided trade. If an investor made the decision they wanted to limit their own risk to a fixed amount for each trade, then a volatile stock will require the stop-loss to be further away than a much less volatile stock. This will figure out how many shares they buy.

For example, if stock A is actually volatile and trading at $10, a trader might decide to use the 20% stop loss level from the entry price. That’s $2 below the entry price. If they wanted to risk $1,000 per trade, then they would buy 500 shares.

That’s calculated by the risk quantity ($1,000) divided by the stop-loss amount ($2 — that’s 20% of $10), to provide you with 500 shares.

Now, if stock B is also trading from $10 but less volatile, a trader might use a 10% stop loss underneath the entry price. That’s $1 underneath the entry price. Again, if they wanted to risk $1,000 for each trade, then they would purchase 1,000 shares.

That’s determined by the risk amount ($1,000) divided by the stop loss quantity ($1 — that’s 10% of $10), to give you One,000 shares.

While these are simple examples, they do show you that there’s a relationship between the number of gives you buy and the underlying unpredictability.

Slippage

One thing you need to always be aware of is slippage. Just because you place a stop loss level in a specific price, it doesn’t mean that you’ll always be filled at that price. You have to think of a stop loss as a ‘trigger’.

Once the stop loss price is hit, it triggers your exit trade into the market. If there are no buyers at that level, you very well may get filled at a lower price than you anticipated. While there might be less chance of this happening with a big blue chip stock, it’s something you need to be conscious of. Especially with smaller, more speculative stocks.

For example, let’s say an investor has a stop loss at $6.50 and the share price closes tonight at $6.60. If the marketplace opens tomorrow at $6.Forty, then their stop loss is actually triggered. In effect, the order has become ‘live’.

However, they won’t get $6.50 since the price never traded there. Instead, it will be filled at the first available price on the market. In this example, it might be $6.Forty. Or, it could be lower. Your own exit trade needs to be matched up with a buyer before the trade will go through.

Some brokers will help you to limit the maximum amount of slippage you’ll accept before not putting the trade. If any doubt, give your broker a call and ask how them how their trading platform works.

Trailing stops

A trailing stop loss is simply as the name implies. Instead of the stop loss level remaining fixed at the same level, it shadows the price movement from the underlying share. As the stock price moves up, also does the stop less degree.

The most common way to do this is to maneuver your trailing stop at a set percentage level behind the proportion price. While you might start with the percentage you set your stop loss from, it doesn’t mean that you have to stick with it.

If the actual chart shows that the price is starting to flatten out or change direction, a trader might decide to tighten the stop-loss percentage to trigger an exit. That is, to lock in a profit. For some, this can give a clear cut way to manage their trades. It stops them from trying to guess when you should get out of a trade. In effect, it takes the emotion from the decision.

These strategies revolve around the cost of the stock. But the cost isn’t the only thing to make use of when working out your exit strategy.

Other exit strategies

Quite often an investor might find that, if a stock doesn’t go in their path to start with, then it might not go their way at all. Probably the trend they bought into has lost momentum. That is, just as they buy into it, the stock starts to trade sideways.

One way to manage this is by using ‘time stops’. A time stop takes you from your trade after a fixed time period. The time frame you choose will depend on your own trading strategy. For a day trader it might be as short as Half an hour. For a trader working on a weekly time scale, it might be a single day, or they may make use of the open of the second day as an exit trigger.

It might be that they haven’t lost any money at all. However, there are only a lot of trades they can do from any one time with their account. So, they want to avoid tying their money up in a industry that isn’t going anywhere.

And obviously, there is always technical analysis. It might be something as basic as a five day moving average crossing over a 30 day moving average.

As you can see, there are a multitude of different exit strategies you can use. It might be based on fundamental data — a trader might exit once a stock exceeds a certain P/E ratio. Or even, if a dividend yield begins creeping up to what appears like an unsustainable level, then this could trigger an exit.

Whichever technique you use, a stop loss is a really important tool to help you keep your cash when the market requires a turn for the worse.

What’s ahead for 2016

As I wrote at the beginning of this update, I think 2016 may throw us more unpredictability. In doing so, the market will also give us more opportunities to buy into high quality stocks at better costs than you could in a runaway bull market.

It’s a year that will reward the patient investor.

I’m really looking forward to getting stuck in to the markets in 2016. Here’s wishing that it will be a prosperous year for everyone.

Regards,

Matt Hibbard,

Editor, Total Income

Ed Note: This is an edited extract from a Total Income update. To find out more about Total Income click here.

From the Port Phillip Posting Library

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