A Discussion on Stop Losses

With our recent launch of HX Research, we have received questions from our readers about various aspects of our approach.

We have outlined every part of our method in our investment primers for our publications - HX Trader, HX Income and HX Legacy. These documents are excellent summaries of the methodology we developed over the last three decades and are available to our paid subscribers.

The one question, though, that we get most often is about “stop losses.”

For those unfamiliar with the term, a "stop loss" is the idea that you automatically close out a position if you hit a certain amount of loss. Usually, this is the price at which you close it out.

On the surface, most (all?) of the great traders and investors out there are advocates of a stop loss. Managing your losses is crucial to your long-term success as an investor.

Speak to many investors, and you will hear stories about how stop losses have cost them much money over time.

The solution is to use a more sophisticated method. Very few successful investors employ a simple "price" stop loss.

Neither do we.

On the back of reader questions, we thought today we would walk you through the stop loss methodology for our products.

Yesterday’s HX Daily discussed the difference between TRADING and INVESTING. You can read that note here.

At HX RESEARCH, we have two products focused on trading – HX Trader and HX Income – and one focused on investing – HX Legacy.

Each of these takes a different approach to a stop loss.

In trading, we are focused on the price of the stock and technical analysis. We are looking for short-term gains and respect whether the stock market responds to our idea.

Let's imagine we are right about the fundamentals, but the stock is not acting accordingly. We are likely to get out and move on to another position. In trading, we are primarily focused on price and not fundamentals.

Our focus on the price, though, must be focused on what is going on with the stock and not the stock market.

What do we mean by this?

A stock can go down for two reasons. It can go down because of something happening with the company, or it could go down because of something happening with the overall stock market.

The first instance – something with the company – is the one that concerns us the most. When a stock goes down, and the overall stock market does not, something is wrong with that particular stock. This is what we want to avoid.

If a stock goes down with the market, there may or may not be something wrong with the stock, but almost always, a significant downturn in the stock market will bring all stocks down.

Think of it this way – a falling tide doesn’t mean the ship is sinking!

This is why, in our trading strategies, we utilize a method called an "alpha" stop loss.

“Alpha” in the finance world means the performance of a stock versus the stock market.

If the market is +5% and your stock is +25%, the stock has produced a positive alpha of +20%. This is great. It means you are doing much better than just owning the stock market. Picking that stock added value.

Conversely, if in that market (the +5% market), your stock is -10%, then you have produced a negative alpha of -15%. This is obviously bad.

For our trading strategies, we look to close out a position if it produces a negative alpha of at least -15% to -25%. This means it has decreased at least that amount against the overall stock market.

Why not just a single number?

The reason is that different stocks have different volatilities or the amount by which they move.

For a low-volatility stock, the number will be smaller. For a high-volatility stock, it will be higher.

Does this stop-loss work for our strategies? Absolutely!

Do you use a stop loss? Has it helped your investing? Tell us in the comments section at the bottom of this post.

After running our strategies at Empire Financial without a stop loss for the first few years, we developed this stop loss.

In year three, we went and looked and saw several more considerable losses that we thought could have been avoided with a better process.

We back-tested and came up with the method that we use today.

We found out that using this method would have improved our returns by +1% to +2% per year. That is not a huge number, but with the strategy churning out high single-digit or low double-digit returns, it counts.

More importantly, it kept us from taking on big losers.

Remember that our trading strategies have very high "hit rates ."This means they win much more often than they lose. Historically, they have produced positive returns almost 75% of the time.

The key is ensuring that when you do lose, you manage how much you lose and don’t let it be too big.

On another note, later this week, we will talk about our stop-loss method for INVESTING strategies.

Check out Enrique Abeyta’s conversation with JC Parets on the HX Podcast.