Ask Colin

I have heard that a portfolio should have a stop-loss at 2%. What do you recommend?

In your extended question, you seemed to be defining the portfolio value as the total of the market value of all shares held plus cash. This is the standard definition. If it is plotted over time, it will give what industry jargon refers to as an equity curve. Next, you seemed to be defining the 2% with reference to the high point of the portfolio value, or equity curve. This is fine, I am just restating it so we and any readers in my newsletter or website know what was in your extended question.

The first thing that I would say is that this is a very close stop-loss for a portfolio. It is common to have such a stop-loss based on the purchase price of a single stock, if brokerage and slippage are included. Myself, I aim for at the most 1% stop-loss on a single stock, not including brokerage and slippage. The end result may be similar, except that I rarely go as high as 1% and will more commonly have a risk of 0.3% to 0.5% on a single stock.

Note that this is a stop-loss on the cost of buying the position. As it moves into profit, I will raise the stop, which then becomes a protect-profit stop. I do not worry about how big the protect profit stop is. My stop-loss is to protect capital. My protect-profit stop is what it says, but can be wider depending on how the trend unfolds. I am prepared to give back much more than 2% in a profitable position in order to catch the big moves.

I do not have a stop-loss for the overall portfolio. However, on a cost basis, if I have about 20 positions each 0.5% stop-loss, I would be risking 10%, which is the maximum I would tolerate. In fact, I would only sometimes be in this position, because my market exposure strategy, which you have read on my subscription website, would have me with less than 100% of my portfolio in the market a lot of the time. Only in the first roughly three quarters of a bull market will I be 100% invested.

However, other traders and investors have portfolio limits. One of the best known is Dr Alexander Elder, who stops trading if he loses 6% of his portfolio in a month. He then does not allow himself to trade again until the next month.

My view is that a 2% drawdown on your equity curve is too close. If you are trend trading, you need to allow the market more room that that. However, the golden rule is that if any one stock hits its stop-loss, you must close it out immediately.

If the market runs against you, you can calculate how much you have at risk on any one day by taking the difference between the market price and the stop-loss on every stock, totalling the risks and expressing them as a percentage of your portfolio value. If this is too high for you to tolerate, then you should take off some of the worst performing positions.

This is simply matching your risk tolerance to your portfolio. You should then sit down and rethink your trading or investment plan. You should not be in the position where you take more risk than you can tolerate, so you should examine how you got into that position and how to avoid it next time.

However, I suspect from your full question that you accumulated some big gains and are nervous about giving them back in a correction. In this case you have some different thinking to do. This is part of the game of trend trading. It is not easy to sit with big paper profits at risk. If you cannot do it then your plan is not suited to your current risk tolerance. You need to change the plan somehow. Maybe you are not ready to be a trend trader. Perhaps you should be a swing trader on most of your portfolio and a trend trader on only part of it. I suggest you read Dr Elder's book Come into my Trading Room on this subject - I could not put it any better than he does in Chapter 6.

The way I deal with big paper profits is to take part of them progressively. I am very aggressive with this, in that I want a stock to double before I take some profit off. There is nothing to say you could not take profits before this. My idea is that when a stock really goes up many times over, it is very difficult for even the best traders to stay with it. The temptation is to sell the lot. I think it is better to have some of the position still running for as long as the trend continues.

Keywords: