09 February 2007

The Stop-loss Order - Why Aren't You Using It?

What is a Stop-loss Order?

It is an order placed with a broker to buy or sell once the stock reaches a certain price. A stop loss is designed to limit an investor's loss on a security position. Setting a stop loss order for 10% below the price at which you bought the stock will limit your loss to 10%. For example, let's say you just purchased RELIANCE at Rs.500.00 per share. Right after buying the stock you enter a stop loss market order for Rs. 450.00. This means that if the stock falls below Rs. 450.00 per share your shares will then be sold at the prevailing market price.

Positives and Negatives

The advantage of a stop order is you don't have to monitor on a daily basis how a security is performing. This is especially handy when you are on vacation or having a full time job that prevents you from watching your security for an extended period of time.

The disadvantage is that the stop price could be activated by a short-term fluctuation in a securities price. The key is picking a stop-loss percentage that allows a security to fluctuate day-to-day while preventing as much downside risk as possible. Setting a 5% stop-loss on a security that has a history of fluctuating 10% or more is not the best strategy: you will most likely just lose money on the commissions generated from the execution of your stop-loss orders. There are no hard and fast rules for the level at which stops should be placed. This totally depends on your individual investing style: an active trader might use 5% while a long term investor might choose 15% or more.

Another thing to keep in mind is that once your stop price is reached, your stop order is a market order, the price at which you sell may be much different from the stop price. This is especially true in a fast-moving market where stock prices can change rapidly.

Not just for Preventing Losses

Stop loss orders are traditionally thought of as a way to prevent losses. (After all, it's called a "stop loss" for a reason.) Another use of this tool, though, is to lock-in profits, in which case it is sometimes referred to as a trailing stop.

In all forms of long-term investing and short-term trading, deciding the appropriate time to exit a position is just as important as, if not more important than, determining the best time to enter into your position. Buying (or selling, in the case of a short position) is a relatively less emotional action than selling (or buying, in the case of a short position). When you enter a position, the potential for realized profits is but a dream and the possibility of losses is only a vaguely considered nightmare.

By contrast, when it comes time to exit the position your profits are staring you directly in the face, but perhaps they are telling you that there is potential for even greater profitability if you were just to ride the tide and exercise a little bit more patience. In the unthinkable case of paper losses, your heart tells you to hold tight, to wait until your losses reverse and the passage of time brings you into a profitable position once again.

But such emotional responses are hardly the best means by which to make your selling (or buying) decisions. They are purely unscientific, and the presence of emotion brings you as far from a disciplined trading system as can be imagined.

Trailing Stop-Loss

The most basic technique for establishing an appropriate exit point is the trailing stop technique. Very simply, the trailing stop maintains a stop-loss order at a precise percentage below the market price (or above, in the case of a short position). The stop-loss order is adjusted continually based on fluctuations in the market price, always maintaining the same percentage below (or above) the market price. The trader is then "guaranteed" to know the exact minimum profit that his position will garner.

Here, the stop-loss order is set at a percentage level below not the price at which you bought it but the current market price. The price of the stop loss adjusted as the stock price fluctuates. Remember, if a stock goes up, what you have is an unrealized gain, which means you don't have the cash in hand until you sell. Using a trailing stop allows you to let profits run while at the same time guaranteeing at least some realized capital gain.

To use our Reliance example from above, say you set a trailing stop order for 10% below the current price, and the stock skyrockets to Rs. 800.00 within a month. Your trailing stop order would then lock-in at Rs.720.00 per share (Rs.800 - (10% x Rs.800) = Rs.720). This is the worst price you would receive, so even if the stock takes an unexpected dip, you won't be in the red.

Limiting Losses

It is simply not possible for any trader--whether amateur, professional or anywhere in between--to avoid every single loss. The disciplined trader is fully cognizant of the inevitability of losing hard-earned profits and, as such, is able to accept losses without emotional upheaval. At the same time, however, there are systematic methods by which you can ensure that losses are kept to a minimum.

A 2% Limit of Loss

A common level of acceptable loss for one's trading account is 2% of equity in the trading account. The capital in your trading account is your risk capital, the capital that you employ (that you risk) on a day-to-day basis to try to garner profits for your enterprise.

The loss-limit system can even be implemented before entering a trade. When you are deciding how much of a particular trading instrument to purchase, you would simultaneously calculate how much in losses you could sustain on that trade without breaching your 2% rule. When establishing your position, you would also place a stop order within a maximum of 2% loss of the total equity in your account. Of course, your stop can be anywhere from a 0% to 2% total loss. A lower level of risk is perfectly acceptable if the individual trade or philosophy demands it.

Every trader has a different reaction to the 2% rule of thumb. Many traders think that a 2% risk limit is too small and that it stifles their ability to engage in riskier trading decisions with a larger portion of their trading accounts. On the other hand, most professionals think that 2% is a ridiculously high level of risk and prefer losses to be limited to around half or one-quarter of a percent of their portfolios. Granted, the pros would naturally be more risk averse than those with smaller accounts--a 2% loss on a large portfolio is a devastating blow. Regardless of the size of your capital, it is wise to be conservative rather than aggressive when first devising your trading strategy.

Monthly Loss Limit of 6%

So, you have now established a system whereby your loss from each individual trade is limited to 2% of your risk capital. But it doesn't take a rocket scientist to realize that even losing a moderate 1% of your account's value in ten days within a month results in a rather devastating 10% of your account's value within that month (notwithstanding any profits that you might have made in the other twelve-odd trading days within the month). In addition to limiting losses from individual trades, we must establish a circuit breaker that prevents extensive overall losses during a period of time.

A useful rule of thumb for overall monthly losses is a maximum of 6% of your portfolio. As soon as your account equity dips to 6% below that which it registered on the last day of the previous month, stop trading! Yes, you heard me correctly. When you have hit your 6% loss limit, cease trading entirely for the rest of the month. In fact, when your 6% circuit breaker is tripped, go even further and close all of your outstanding positions, and spend the rest of the month on the sidelines. Take the last days of the month to regroup, analyze the problems, observe the markets, and prepare for re-entry when you are confident that you can prevent a similar occurrence in the following month.

How do you go about instituting the 6% loss-limiting system? You have to calculate your equity each and every day. This includes all of the cash in your trading account, cash equivalents, and the current market value of all open positions in your account. Compare this daily total with your equity total on the last trading day of the previous month and, if you are approaching the 6% threshold, prepare to cease trading.

Employing a 6% monthly loss limit allows the trader to hold three open positions with potential for 2% losses each, or six open positions with a potential for 1% losses each, and so forth.

Making Necessary Adjustments

Of course, the fluid nature of both the 2% single trade limit and the 6% monthly loss limit means that you must re-calibrate your trading positions every month. If, for example, you enter a new month having realized significant profits the previous month, you will adjust your stops and the sizes of your orders so that no more than 2% of the newly calculated total equity is exposed to a risk of losses. At the same time, when your account rises in value by the end of the month, the 6% rule of thumb will allow you to trade with larger positions the following month. Unfortunately, the reverse is also true: if you lose money in a month, the smaller capital base the following month will ensure that your trading positions are smaller.

Both the 2% and the 6% rule allow you to pyramid, or add to your winning positions when you are on a roll. If your position runs into positive territory, you can move your stop above break-even and then buy more of the same stock--as long as the risk on the new aggregate position is no more than 2% of your account equity, and your total account risk is less than 6%. Adding a system of pyramiding into the equation allows you to extend profitable positions with absolutely no commensurate increase in your risk thresholds.

Why is a Stop Loss Order recommended?

First of all, the beauty of the stop-loss order is that it costs nothing to implement. Your regular commission is charged only once the stop-loss price has been reached and the stock must be sold. It's like a free insurance policy!

Secondly, but most importantly, a stop-loss allows decision making to be free from any emotional influences. People tend to fall in love with stocks; we believe that if we give a stock another chance, it will come around. This causes us to procrastinate and delay, giving the stock yet another chance and then yet another. In the meantime, the losses mount....

No matter what type of investor you are, you should know why you own a stock. A value investor's criteria will be different from that of a growth investor, which will be different still from an active trader. Any one strategy may work, but only if you stick to the strategy. This also means that if you are a hardcore buy and hold investor, your stop-loss orders are next to useless. If you plan on holding a stock for the next decade there is no reason to place a stop. The point here is to be confident in your strategy and carry through with your plan. Stop-loss orders help us stay on track without clouding our judgment with emotion.

Finally, it's important to realize that stop-loss orders do not guarantee you'll make money in the stock market; you still have to make intelligent investment or trading decisions. If you don't, you'll lose just as much money as you would without a stop-loss, only at a much slower rate.

Conclusion

The 2% and the 6% rules of thumb are highly recommended for all traders, especially those who are prone to the emotional pain of experienced losses. If you are more risk averse, by all means, adjust the percentage loss limiters to lower numbers than 2% and 6%. It is not recommended, however, that you increase your thresholds--the pros rarely stray above such potential for losses, so do think twice before you increase your risk thresholds.

A stop loss order is such a simple little tool, yet so many traders fail to use it. Whether to prevent excessive losses or to lock-in profits, nearly all investing styles can benefit from this trade. Think of a stop loss as an insurance policy: you hope you never have to use it, but it's good to know you have the protection if you need it.

This article is to brief you about stop-loss, their uses, advantages and disadvantages.

04 February 2007

Should you scale the Vistas?

Long long back (almost 12 years) I read an article in a newspaper about how Microsoft and Intel ensure their continued business growth and profitability.

You may say technology. I will say, business acumen (or plain cheating?)

Have you noticed that whenever Windows comes up with a new version of its software, you will be more often than not required to change (read upgrade) the hadware?

There lies the scheme of BillG and Intel. Microsoft will keep churning out software that will demand more and more of machine power and Intel will keep churning out the power that Microsofts power hungry and space hungry software will demand.

I remember the good old days when we had a simple PC that worked on a operating system that occupied nothing more than one five and a quarter inch floppy and programs (many) that won't go beyond one or two five and a quarter inch floppies.

We were living in the world of NO, yes, you heard it right, NO hard drives. We have experience of working with a RAM that didn't exceed 640KB. Our computers of those days had no knowledge to use 1 MB memory even if we upgraded. We needed to use some fancy software to reassure the computer that there was actually some more memory it can use.

For maths calculations (leave alone graphics display) we were installing a separate chip called maths processor. That speeded up our 1+1=2 calculations.

Now we get pen drives that have almost 100 times more capacity than the early hard disc drives used by us in the 1980s. We get hard drives these days that have capacities that ''I cannot calculate how many" times the storage of yesteryear hard drives. We get computers with 1 GB RAM.

Still, instead getting contended and developing software to use up these mega capacities, Microsoft comes up with software that wants more space, more power, more memory and in the process makes what you already have obsolete though they still have lot more years of life left in them. Imagine how many trillions of bites hard disc space is remaining unutilised in this modern world. When I last checked my computer, I had 60% of my hard disc space not used at home and over 70% unused at the office (?) and these two will total up about 100 GB unused.

Imagine buying a car paying a huge sum of money and then the company that makes petrol comes up with a new version of petrol every second or third year so you have to throw away the car and buy a new powerful one so that you can enjoy the experience of using the new version of petrol.

Isn't it sheer madness?

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Three versions of Windows Vista confront buyers. That is not to say that PC owners — at last count there were about 50 million of them in India, 9 out of 10 being users of an earlier Windows version — know quite what to do now.


This is partly because Microsoft, while asking us to say `wow!' at all the new features, has been rather coy with practical details — like who must upgrade, who would be better off upgrading — and how much it is all going to cost.


Launch event

The main launch event in Mumbai was replete with Bollywood `masala' — but scant on earthy details such as how much each of the confusingly plentiful `avatars' of Vista will set us back in rupees.

Here's some help: There are three consumer versions of Vista that one can buy off the shelf — and a fourth called Starter Edition that is special to India: It will be only be sold pre-installed on entry-level PCs marketed here.

The three `shrink wrapped' versions range from the Home Basic, for those who browse the Net, write letters and e-mails — and do little else with their PC. If your PC has multimedia attachments that allow you to watch movies, play music and play graphics-rich games, the Home Premium version is for you (It corresponds roughly to what was called Windows XP Media Centre Edition).

For those who want to mix business and pleasure — the full suite of office functionality as well as infotainment features — there is Windows Vista Ultimate. But, you still need to separately install the latest version of the productivity suite, Microsoft Office 2007, to get most of the common business features.

Basic hardware

Microsoft says the basic hardware required is a modern chip (that is 800 MHz or faster); 512 MB of memory, 20 GB of hard disk and a graphics processor with what is called DirectX 9. This might just work for the Starter edition — but except allowing you to search both your desktop and the Internet with a click or two, it will miss out on most the features that take Vista beyond the old XP.

Our take: If so, why bother to upgrade? For the Premium and Ultimate versions, Microsoft recommends 1 GB of memory and a graphics card with at least 128 MB of its own memory. It also suggests at least 40 GB of hard disk. All three versions will take up about 15 GB of your disk space. After trying out the evaluation editions, we think users will need at least 2 GB of RAM to (as a famous petrol slogan of yesteryear went) ``fill up and feel the difference.''
The difference is mainly the much-touted Aero effect where 3D combined with a translucent `glass' effect has all your pages and open applications seeming to stand up in a see-through file on the screen. All versions boast of extremely user-friendly `parental controls' to monitor kids' surfing — and enhanced security features against junk mail (spam) and malicious mail — but it is too early to say how effective they are. And be warned: you still need to install a third party anti-virus software — unless you like to live dangerously.

Key question

Now the key question: Which Vista will work on your present PC? Microsoft has created a special download called Vista Upgrade Adviser at http://www.windowsvista.com,/ which examines your hardware and software and recommends what will work best for you. When I tried it on my AMD Athlon XP 2400-based PC currently running Windows XP, it suggested I could go in for Home Premium but it warned that my Xerox laser printer and Nero software for a Samsung Combo CD-DVD drive might not work. It has no issues with my HP deskjet printer.

Common peripherals

This is likely to happen with a lot of common peripherals. Our feedback is that the problem will bug many users for at least 6-8 months more since there are hardly any accessories or PC devices that include a Vista driver today.

So finally: Who should upgrade? If you are currently running a version older that XP — like Win 98 — then you have no choice since you are stuck with a `dead' version: You might as well change to one of the new Vista versions. If you are buying a new PC or laptop, it is good to insist on getting a Vista flavour pre installed. This will probably be cheaper than buying one separately since the shop shelf cost is likely to be Rs. 6000 to Rs. 10,000 at least (this is our market perception; Microsoft is not saying). If you are a Windows XP user you might like to change to Vista — if you must have the undoubtedly strong safety and search features. Or you might like to `wait and watch' till the compatibility issues are sorted out.

Have you seen my other blog?

03 February 2007

Turnaround Solutions

If you are looking at a multibagger in this heated market which is inching closer to 15K and is doubtful if there are any such multibaggers left.  Read on.  You can take a safe bet on IFCI, the surviving pure development financial institution with mouth watering stakes in some of the best companies in the country including National Stock Exchange and ICRA besides stakes thru loans converted into equity over the years and hold on many properties pledged as collateral.
 
At Rs.25 its a mega BUY and if you don't do it now, after 5 years you will brood not acting even after reading this blog.  I have blogged.  Now you have to log in for mega profits from your investments.
 
IFCI is back in the black, but what's its game plan?
 
After spending five years in the red, the country's oldest development financial institution (DFI), IFCI, is back with a bang. Not only has it shown a profit for the first half of 2006-07, last fortnight, it also received a Rs 780-crore bonanza from the sale of its stake in the National Stock Exchange. And there may be more good news in store.
 
Credit rating agency ICRA, in which IFCI has a 21 per cent holding, is slated to hit the capital market some time this year. IFCI has already informed the bourses of its intention to offload its stake in ICRA.
 
IFCI also owns 19 per cent in the listed Travel Finance Corporation of India (TFCI); that holding is valued at some Rs 25 crore at current prices. Although there are no concrete proposals to sell equity in other smaller companies, IFCI says in the normal course of business it keeps on disinvesting, in small quantities, its holding in listed companies through stock exchanges.
 
What's most heartening for IFCI, however, is the turnaround. "Concerted efforts on the recovery front and restructuring of liabilities have helped in the turnaround of the institution," says Sanjoy Chowdhury, Chief General Manager at IFCI. Over the longer term, though, the problem for IFCI is that it still dabbles in project finance and project advisory, where the scope of returns is limited.
 
Which is why contemporaries like ICICI Bank and IDBI have today become full-fledged banks, with a sharp focus on retail banking. However, a former IFCI director feels IFCI can hold its own as a DFI. "There is a void created in the DFI space in India. Globally we have established DFIs like 3i in the UK, KFW in Germany and Japan Development Bank (JDB) in Japan," he maintains. Yet, to ensure IFCI's survival, a long-term game plan needs to be chalked out. "The options on the table are a merger with a stronger institution or a strategic partner," says a top official of IFCI.
 
Thanks - Business Today