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Trading Tips and Techniques Issue 1, Dec 2000

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Disclaimer: BDG Australia Pty Ltd (ABN…) is not a licensed investment advisor. These notes are based upon existing public-domain
information and/or our own experience in technical analysis. This newsletter is a tool to assist you in your personal judgement and it is not
designed to replace your Licensed Financial Advisor or your Stockbroker. It has been prepared without any regard to any particular person’s
needs. This information is of a general nature and you should get professional financial advice as appropriate before taking any action. The
decision to trade or not to trade is that of the reader alone. The author and publisher expressly disclaim all and any liability to any person in
respect of anything and of the consequences of anything done or omitted to be done by any such person in reliance, whether whole or
partial, upon the whole or any part of the contents of this publication.

Stop-Loss: A Most Important Tool For Any

Trader.

by Mike von Bertouch

mike@mytradingtool.com

What Is A Stop-Loss?
As Daryl Guppy so succinctly stated in his book Share Trading “…any fool can enter the market. All that is
required is money, a broker, and the willingness to buy stock…”
It’s quite common among novice (and as commonly not-quite-so-novice) traders to buy a stock based upon
‘instinct’, a hot tip from a knowledgeable cab driver, or perhaps one your neighbour’s brother-in-law assured you
was a good thing. You then anxiously crouch over your brokers quote page on the web waiting for it to rocket
into the stratosphere and make a killing…
But – and there’s always a but - when do you get out?
What happens when the stock price slides down and you’re hanging on because your ego can’t stand to lose.
After all, you only lose money if you sell below your purchase price, so if you don’t sell you haven’t lost…
Just as bad, the stock could go from $1.20 to $8.50 and back to $1.90 before you have the courage to exit
‘because you just wanted to get that little bit more out of it’.
Knowing when to exit is far more important than knowing how or when to enter.
This is where we use the concept of a Stop-Loss to provide a clear rule for defining an exit point. This performs
two important functions:
• it protects your investment so if the price drops you will not lose;
• and it provides a logical exit when an upward price trend inevitably reverses to move back down.

Definition STOP (or STOP-LOSS) ORDER; An order to sell a stock when the price falls to a specified level.

A stop-loss order allows you to set a Stop Point below the current stock price and then it is sold as soon as the
price moves below that price. Stop points are never adjusted downward; they are only adjusted upward to

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follow the stock price. If the stock makes a large gain you don’t want you stop languishing too far below the
last price otherwise it has no value.

Lets look at the example in Figure 1:

Figure 1 - Stop-Loss Example

Guaranteed break-even; stop-loss Sell as price crosses

has moved above buy price through stop-loss

Buy here at $4.56

Stop initially
set at $4.20

3G screenshot, www.mytradingtool.com

This stock was purchased at $4.56 with a stop-loss initially set at $4.20. If the price was to drop below the stop-
loss then the stock is immediately sold as close to the stop point as possible.

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What this means is if the price moves down, you are protected from losing more than the difference between
your buy price and the stop price. All you are risking is the difference between your buy and the stop, in this
case $0.36 or only 8% of your purchase price. Using this example it is easy to imagine how, if you selected 10
stocks at random and applied a stop-loss, even if 5 of them were to lose and your losses were limited to only
8% and the remainder gained an average of say 15%-20% over a period of time you would make money by
following the #1 rule for trading: cut your losses and let your profits run. This example highlights the
safety and value of managing risk without knowing anything of stock analysis and selection techniques.
Going back to the example of Figure 1, as the price of the stock moves upward your stop-loss also moves
upward. As the stop-loss crosses above your buy price, you are now assured of breaking-even. You will always
realise a profit if the stop-loss is above your buy price.
This illustrates the first and primary function of a stop-loss: protecting your investment.
As the price eventually starts to reverse its upward trend, you will be automatically taken out of the position
when it reaches your stop-loss.
This illustrates the second, also important, function of a stop-loss: an objective exit decision point.

How Do I Select a Stop-Loss?

A stop-loss can be determined using a number of approaches. At a fundamental level, there are two types of
stops: a fixed stop and a trailing stop.
Fixed stops are simply as described; you decide when you purchase a stock where to set a stop loss and
periodically you review its position, moving it upwards say every 1 or 2 weeks loosely following an upward trend.
Trailing stops use a predetermined method for following the price movement. There are a number of different
techniques available to calculate an appropriate stop-loss from the simple through to the complex. All however
have the same objective – to limit risk and objectively provide an exit point.
We will discuss a particular trailing method called a Countback method. This method was refined by Daryl
Guppy from the 3-Bar Nett method developed by bond trader Joseph Stowell.
Any trailing stop method should provide protection from minor swings and reversals of trends and take into
account volatility. The countback method effectively does this and although its not a castor-oil ‘one-size-fits-all’
approach you may find it a useful technique.

Constructing a Countback
The steps to calculating a countback are shown below. To start this process, assume its early evening and you
have just downloaded today’s price data and have decided to ring your broker tomorrow morning and place a
buy order:
Step 1 Draw a horizontal line from today’s low price backwards until it runs into a day with a lower low price.
This is your 1st countback.
Step 2 From the low price of this new lower day, again draw a horizontal line from it’s low price backward
until it runs into a day with a lower price. This is your 2nd countback.
Step 3 From this second lower day, draw a horizontal line from its low forward to the current date. This line
is your stop-loss when you place your order.
These three steps are shown in Figure 2.

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Figure 2 - Countback Illustrated

C B A

Countback #1

Countback #2
Extend forward 2nd low,
this becomes the stop-point
From today’s data (remembering for this example it is early evening and you already have today’s data) which is
indicated by ‘A’ above, a horizontal line is drawn back until a day with a lower low price is found, ‘B’. This is
repeated from B’s low price until a lower low is found at ‘C’. The low price of ‘C’ then becomes your stop-loss
when you enter the market tomorrow morning.
Lets now jump forward to the end of the next day. Again you have just downloaded today’s data and you went
long during the day. We apply exactly the same approach we did yesterday to calculate a new stop-loss value
for tomorrows trading. If you look at Figure 3 you can see the same rules are applied to the latest data to
recalculate the stop-loss point. The low of our new ‘A’ (today) is extended back until a lower low is found. This
happens to be yesterday which is now our new ‘B’. ‘B’s low is extended back until we find a new ‘C’. The low of
‘C’ is extended forward to today and we now have a new stop position slightly above yesterdays starting stop-
loss.

Figure 3 - Countback Illustrated, 2nd Day

C B A

Countback #1

Countback #2
Extend forward 2nd low,
this becomes the new stop-point

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Lets now define some rules to use in constructing a countback stop-loss:

Rule 1 You NEVER move a stop downwards. If you calculate a new stop loss lower than your
previous you discard it. This rule can never be broken.
Rule 2 Ignore days that have the same low price as that of your countback line. For you to select
a new low price for the second countback, it must be lower than the first. If you cross a bar with
the same low price just keep on going until you find a lower one.
That’s all there is to it really. Applying these rules we can now extend our stop-loss upward as ech new days
data is added as shown in figure 4. On day ‘H’, the 1st countback line would find a day with the same low price
at ‘I’ however according to rule 2 above we ignore this and keep on going back until a lower low is found from
which we start our second countback.
Rule 1 is illustrated on the last day ‘J’ where if the two countbacks are performed we would have the low price
of day ‘H’ as our stop-loss. This is below the last stop-loss so we discard it. This is essential, never under
any circumstances lower your stop-loss.

Figure 4 - Countback In Action

I H J

Figure 5 shows the next day where the price crosses below the stop-loss. The stock would have been sold
during the day when the stop was crossed. It is important to point-out that the stock is not ‘automatically’ sold
just because your calculation said it should. You need to contact your broker each day that an adjustment of the
stop is required. Alternately if you are trading online it is advisable to use a broker with an alerting system such
as SMS messaging that allows you to be notified when the stop is reached so you can go to the website and
process the sell manually.

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Figure 5 - Countback Exit

Exit as price crosses below

stop-loss

In Conclusion…
Stops are an essential part of successful trading. They both remove guess-work and subjectivity from exit
decision making and protect your position.
The countback method is a simple trailing method that takes into account price volatility and generally ignores
small reversals.
You may also want to try this approach for going long by using it in reverse; ie countback high prices in a
downward trending stock to look for a trend change. In this case when the stock crosses above this start-gain
line this can be considered as evidence of price trending upwards.
If you want to experiment with an automated countback stoploss indicator to get a ‘feel’ for its effectiveness, go
to www.mytradingtool.com and try it out for free using the 3G online charting service.

References and further reading…

Guppy, Daryl Share Trading, 1996 Wrightbooks Pty Ltd, www.wrightbooks.com.au.
Stowell, J Tips for Traders and Investors, Money Management Institute.
Stowell, J Stocks & Commodities Magazine, July 1995.

Copyright © 2000-2001 BDG Australia Pty Ltd, This article may be retransmitted via the internet freely. No part may not be otherwise
published or duplicated by any means electronic, mechanical, photocopying, recording or otherwise without prior written permission.