Recently, I received the following email: "Would it be possible for Dr. DiLiddo to do an essay on sell stops? I have been whipsawed out of so many good stocks lately due to stocks ranging from 20 to 30 percent below the price only to see the same stocks recover quite rapidly. I end up buying the stock at a higher price if I want to continue to stay with it. I have lost more money that way than if I had just stayed with the stock with very few exceptions.
I called my broker at Schwab and he said he never uses stops as the Wall Street traders have a window to see where the stops are on all stocks and control enough of the stock to sell it down to knock out the stop positions and turn around and buy them when they go back up. I am sure this is nothing new but it is costing all of us a tremendous amount of money. He suggested that I put alerts on stocks so that I could make my own decision if I want to sell or not. I know this only works well enough if you are there to deal with the alert, but it may have some merit.
Even if I try to guess the range the stock is in, it seems to take drastic dips if only for a few minutes and I am sure that is where Wall Street is knocking out the stop prices. It is very frustrating."

Best Regards,

Norm

Ah Norman, I feel your pain. We have experienced the same frustration of having stocks go exactly to our Stop Price, knocking us out and returning to their normal trading pattern. How are we addressing this problem?

Let's see what we have done in managing the Model Portfolio. First of all we have been favoring highly liquid stocks. For example, we decided to buy only the five highest AvgVol Contra ETFs when we went into the market last Tuesday. My belief is that it would be virtually impossible for any trader to manipulate the price action of these actively traded stocks. Next, we bought only five stocks instead of the usual 10 because these particular ETFs behave pretty much the same. Consequently, we would not have received much more diversification by adding additional positions. Of course, having five positions instead of 10 makes it easier to manage the portfolio, but it also increases the percent risk of loss on any single position.

To counteract the problem of higher risk, we chose to use only 50% of our available funds. This decision also allowed us to use a 10% Stop-Loss instead of the 5% we normally use. The wider Stop-Loss Percent helps accommodate the high volatility of these stocks and also makes it harder for traders to knock us out of our positions.

Do you remember the formula that I presented in my February 6, 2009 essay on Risk Management? Well, here it is again:

S = (100 * R * N) / C

Where
S = Stop-Loss Percent.
R = Percent Risk of Loss on any single position.
N = Number of positions, and
C = Percent of Capital employed.

Basically, we like to keep R, the percent risk of loss on any single position, equal to one percent. So with five positions and 50% of our capital invested, we should be using a 10% Stop-Loss. And that's what we have been using.

Now here's how to relieve your frustration, Norman, and make money in this market: First and foremost, you must "let the trend be your friend." I know it wasn't easy to do while we were in the grip of the Wicked Wedge, but you must remain patient and be prepared to take what the market gives you. Last week, we were prepared to go either long or short in our Model Portfolio depending upon what the market gave us. The market went down, so we played the market to the downside with Contra ETFs.

The next thing to do is trade only high volume stocks---say those with an AvgVol of 250,000 shares or more. Then you should use the widest Stop-Loss percent that you can. Let's say you want to keep R to one percent and trade a 10 stock portfolio. Now, if you invest no more than four percent of your available funds into any single position, i.e., employ a total of 40% of your available funds, S = (100 * 1 * 10)/40 = 25%.

That's How to Set the Right Stop-Loss Percent.