A Discussion on Stop Losses – Part II

Earlier this week, we began discussing the benefits and challenges of using a "stop loss" discipline in trading and investing.

Remember, a “stop loss” is a rule you put in place to close out a position if you lose a certain amount of money.

In the last note we wrote about this, we discussed our “stop loss” method we use in our TRADING publications - HX Trader and HX Income.

At the start of the week, we distinguished between TRADING and INVESTING. Both are focused on making you money, but they take very different approaches.

Today, we will discuss our "stop loss" method in our INVESTING publication – HX Legacy.

Returning to our first note, "INVESTING," means we want significant returns on an idea. Think doubling, tripling, or even making ten times your money.

These kinds of return goals have a couple of ramifications.

First, you can't make that kind of money in a day, a week, a month, or often even a year. You need to hold stocks for a long time to make that kind of money. Patience is key.

Second, stocks that can go up a lot like that also tend to be volatile. To have the possibility of going up a lot, you have to accept the possibility of going down a lot!

Do you remember that the “it” stock of the moment – NVIDIA Corporation (NASDAQ: NVDA) – was down -64% in 2022/2023?

Or that two of the most incredible stocks of all time – Amazon.com, Inc. (NASDAQ: AMZN) and Tesla Inc. (NASDAQ: TSLA) – have been cut in half (or much more) a half dozen times in the last few decades?

Significant returns involve significant volatility. Any "stop loss" discipline needs to adapt accordingly.

With our positions in our HX Legacy publication, we still use an initial "stop loss" method that is the same as our trading publications. This method looks at the "alpha" of the position or stock performance versus the stock market, read about it here.

We want to ensure we don't get shaken out of a great long-term stock position due to stock market volatility.

Understanding the underlying stock's volatility in long-term, high-return potential ideas is even more critical than our trading positions.

Have you reacted to market volatility and gotten out of a stock that you wish you had stayed in? Let us know in the comments section at the bottom of this post.

With our trading strategies, we will almost always execute the "stop loss" discipline. We say "almost" because we don't want to discount some extraordinary event. Still, we should be at 95%+ adherence to the discipline.

With our investing strategies, the "alpha" stop loss triggers a review. This review will then focus on the fundamental thesis of the position.

We ask ourselves two questions…

First, do we think that whatever needs to happen for the stock to go up a lot can still happen?

Almost always, we think a stock will go up a lot because revenue and earnings will go up a lot. This is usually a result of them attacking a big market and being well-positioned to do so.

We are very selective when picking our situations, but the situation CAN change.

Maybe there is a technology change. Maybe there is a change in competition. Maybe there is just new evidence that we were wrong.

We will get out immediately if we no longer believe in our thesis. Whether we are losing money or not!

Most often, though, the two are correlated. Positions where we decide we are wrong almost always have lousy stock performance simultaneously.

The second question is whether the company can execute the opportunity.

This is a subtle difference. The opportunity may not have changed, but we don't know if they can exploit it.

You might be technically able to climb the mountain, but that doesn't mean you will end up doing it.

We look to have a relatively small number of ideas in our long-term investing strategy. Maybe twenty to thirty at most. 

This means we not only want to be selective about the long-term, but we want to think about the intermediate-term.

If the ample opportunity remains good but the company has not shown they can execute for an extended period. Think multiple quarters…, and then we are likely to move to the sidelines.

Again, this is not dependent on losing money in the stock, but the two are almost always correlated.

A change in our big thesis and/or poor execution by the company always coincide with poor stock performance.

Your "stop loss" discipline will depend on your goals and strategies.

Our method has been developed across three decades of active investing, and we are comfortable with how it works and our ability to execute it.

Figuring out the "stop loss" part of your investment arsenal may be your most important action!

Listen to the HX Podcast to hear Enrique Abeyta’s conversation with John Roque, Senior Managing Director and Head of Technical Strategy at 22V Research New York.