How to Use Stop Loss Orders to Manage Risk

In the series I penned about the basics of investing, I talked about finding investments, buying them at reasonable prices, and knowing when to finally sell the stock you’ve been holding. But what if you are concerned that you will miss the right opportunity to sell the stock? What if you have a day job that doesn’t allow you to log on to your brokerage account to place any trades?Risk Management

Stop Loss Orders

I want to talk about stop loss orders. Despite the confusing name, they can be really quite simple. This IS Investing Part Time, right? In effect, stop loss orders allow you to set predetermined entry or exit points (i.e. buy or sell prices) for a specific stock. For example, if you own a company that is currently trading at $25.00 per share and you are worried that it might drop rapidly, then you could set a stop loss order at $20.00. If at any point over the next few months you forget to check on this stock each day and it somehow drops to below $20, your brokerage company will automatically close your position and credit your account with the cash sale price of $20 per share.

Stop orders work in the other direction as well. Using the same example, if you think that the company is worth no more than $35 per share based on its current earnings, then you could set a stop order at $35.00. If the share price touches that intraday at any point during the next few months (until you cancel the order), then the position will be closed out too.

A Variation…

A variation of the stop loss order is the trailing stop. This is a bit more advanced of a trade. You can set it up as you would a regular stop loss order, except instead of setting a fixed price, you pick a percentage (say X). The trailing stop will literally trail the upward movement of the stock, and then be limited on the downside. Your brokerage will keep a running number that follows the stock as it advances, but stays put if it is declining. If the stock falls from its peak to an amount X percent lower, your stop order will be executed.

Note: I’m not sure all brokerages support trailing stop orders. If they do, they tend to be a little more expensive, because it is more active than a simple buy or sell order. I use thinkorswim, and here is what an order would look like on their system:

Trailing stop loss

Here’s what it would look like graphically (for AAPL):

AAPL stop loss

How to Manage Risk

As mentioned above, stop loss orders are great for those of us who can’t sit at a computer or keep an eye on the markets all day. We can manage risk by limiting our downside, and lock in profits for a trade that has already been going our direction. I try to have stop loss orders on all my trades, because I never know if I might not have a chance to close out a position and lose an extra 5-10% beyond what was necessary.

How do you figure out what price you should set as your stop loss? It all comes down to the concept of target price (see here for the post I wrote related to that). On the other hand, if you are choosing to place a trailing stop order, the percentage is more subjective. It depends more on your tolerance for risk. If you want to make sure you keep the most profit on a stock that then falls a great deal, a smaller percentage (5-10%) might be suitable. However, in setting a small trailing stop %, you run the risk of the price being hit solely due to day-to-day fluctuations of the stock. The last thing you want is for a stock to fall 5%, trigger your stop loss, and then proceed to rise 40% the next two months. Either way, you take a chance.

Going Separate Ways: Knowing When to Finally Sell a Winning (or losing) Stock

This is the final post of the “Getting Started with Investing” series. So far, it covered why investing now is incredibly important, some investing basics to know, how to choose a brokerage, finding investing ideas, and learning the fundamentals of valuation (Part 1 and Part 2). Now, we are going to finish up with knowing when to sell your beloved stocks when the time comes, regardless of whether they have gone up or down.

Investing is tough. You can spend hours researching specific companies, reading their annual reports, reading all the news and blogs that you can on them, and be totally convinced that they are a great company. The company could then even double in value in a year’s time (or more than triple, in the case of MCP!), and make you incredibly happy. This positive upward movement could last for several years, consistently (see AAPL). But perhaps the biggest challenge facing investors is the question of when it is appropriate to sell.

Enter the Value Investing Approach.

I subscribe heavily to the value investing school of thought. According to it, you buy a company that you find is undervalued and sell short a company that is overvalued. In order to protect your downside, you ensure that there is a sufficient margin of safety. You revisit the investment periodically to gauge if anything fundamental has changed with the company. If so, you revise your analysis and sell if necessary.

This brings us to the important concept of a target price. If you ever read news on CNBC or any of the major financial networks, you will hear this term thrown around quite a bit. The context is usually when an analyst at a big institution (e.g. Raymond James or Credit Suisse) upgrades or downgrades a stock. When they upgrade a stock, for instance, from neutral to overweight, they will sometimes set a target price. Despite there usually being inherent conflicts of interest, these analyst recommendations have a disproportionate effect of the movement of the stock.

Let’s look at an example: Oppenheimer (NYSE: OPY) Analysts Raise Price Target on Dominion Resources, Inc. (NYSE: D) Shares to $46.00. This was just written on January 15th, 2011 (same day as this writing). Even by just reading the title, we can see that Oppenheimer, a big institutional bank and broker, raised its target price on Dominion, a big energy producer, to $46.00.OPY Chart

Now, as I mentioned, this is a very commonplace practice. Big banks love to boost up their target prices for companies for a number of reasons. In the end, it really comes down to helping them make more money. I won’t get deep into the mechanics of why Wall Street is fraught with conflicts of interest, as there are many other good books that do justice to this (off the top of my head, Seth Klarman’s Margin of Safety is a great read on the subject, except for the fact that it is out of print and incredibly expensive). A short list of reasons is as follows: banks encourage trading in the stocks that they promote, thus earning their trading divisions commissions, regardless of whether the stock goes up or down; if banks have a relationship with the company such as underwriting its debt or stock offerings, than this helps the company raise more money, of which the bank can take a cut; finally, banks might have positions in the company they promote, which will increase in value if the stock increases.

Now, despite these three conflicts of interest that I mentioned off the top of my head, investors still use these price targets as part of their “homework” when they buy a stock, regardless of how arbitrary the price is. In the article I linked above, the price target is notably unambitious. Dominion (D) closed the day before this was written at $42.98. A price target of $44.00 represents a massive 2.4% increase on the stock, and the revised price target of $46.00 is a whopping 7% increase. Who wouldn’t want to buy this big winner? In fact, the 52 week range of the stock was from around $36 to $45.12. Therefore, the analyst at Oppenheimer really has no risk of being wrong, as the stock will likely touch its target price because of natural fluctuations in the market.

This is where we come in. Despite how bad I’ve made target prices sound, there is actually a lot of value in them for investors like you and me who use them appropriately. In the previous two posts, I covered how to walk through a basic discounted cash flow analysis. The goal of the DCF is to end up with a target price (or range of prices) at which you’d be willing to buy this company. As I mentioned before, we want to have a margin of safety for the company, so even if our estimates are way off in the DCF model, we will still stand a good chance of making a profit.

Since a DCF model (i.e. absolute valuation) is still quite complex to walk through completely, I’ll show you how to figure out a target price using relative valuation. With relative valuation, we attempt to figure out if a company is undervalued or overvalued relative to its competitors. However, we can get specific if we use certain metrics. One I’ve talked about in the past is the price-to-earnings ratio. This is the ratio of the current stock price divided by the earnings per share of the company. If we know the price-to-earnings for a company as well as its competitors, we could compare them.

Let’s use Goldman Sachs (GS) as an example:


It has a price-to-earnings of just under 10. Its competitors have P/E ratios in a similar range, but on average, they are slightly higher. If we take an average P/E for the group, then we can multiply this by GS’s EPS to arrive at an implied price. I put together this spreadsheet quickly to show what I mean:


All else equal, using the implied P/E of its competitors, GS could roughly trade for a price of $333.50 and not be expensive relative to its peers. This represents a premium of more than 90% on the closing price of $175.00 at the time of writing. But something I noticed in the list of competitors was that Nomura, a Japanese financial institution, had a P/E of 61.55. This seems a bit anomalous, so even if we remove that data point from the average, GS still has an implied price of $240.23 (a premium of 37%). Both of those numbers seem attractive to me.

Closing thoughts

The method I just outlined is probably the easiest way to figure out a target price for your stock. What happens if or when the company hits your target price? Usually at that point, you should either sell or revisit your investment thesis. If you are still comfortable owning it, it makes sense to recompute your target price using the same formula as before (Company EPS times competitors’ average P/E ratio). If your company still seems relatively undervalued, then you will probably want to continue holding onto it!


As I mentioned, this post concludes the Getting Started with Investing series. Now that this is complete, we can move on to more varied topics. Among some of the ideas I have lined up are explanations of common metrics (to be called ‘Metric of the Week’), reviews of brokerages, more book reviews, and helpful things related to 20 and 30 year old personal finance and investing. If you would like to see a topic covered, please leave a note in the comments! As always, I appreciate any feedback that you might have.

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Hedge Fund 13F Season is Coming!

Despite the boring sounding title, this time of the quarter is actually really fun! If you are at all interested in following hedge funds (for the reason of finding out new investment ideas), then these filings are great places to start. As the Investopedia definition says, 13F”s are required by any fund that has over $100m in assets. Basically, this includes all the major funds. Funds are required to list their positions as of the end of the quarter within 45 days after the quarter ends. However, much like a balance sheet, a Form 13F only shows the holdings at a specific moment in time (i.e., a single day).Hedge Funds

That said, there are definitely some caveats to watch for when consulting a fund’s holdings at the end of a quarter. For funds with high turnover, such as a high-frequency trading firm or short term swing trading fund, the 13F’s are probably not valuable, since the fund’s positions have most likely changed significantly since the filing. Some funds included in this bucket are Renaissance Technologies and D.E. Shaw. However, 13F’s are great for value investing funds, because most value investors hold positions for a very long period of time. Some of these funds that I follow personally (and their managers) are:

  • Berkshire Hathaway (Warren Buffett)
  • Baupost Group (Seth Klarman)
  • Soros Fund Management (George Soros)
  • Greenlight Capital (David Einhorn)
  • Pershing Square (Bill Ackman)
  • Appaloosa Management (David Tepper)
  • Icahn Capital (Carl Icahn)
  • Paulson & Co (John Paulson)

These are some of the most well known value funds or activist funds. The links above are to the SEC’s EDGAR search results page for them. If you click on “Documents” next to the 13F-HR filing, then click on the .txt file, you can view the fund’s holdings for this quarter.

Although the document isn’t pretty, it gets the point across. Name of Issuer is obviously the the company itself. Title of class is what type of position the fund holds (“Com” stands for common shares). Market Value and Principal Amount can be used to find out how many shares the fund owns, although most 13F’s disclose that as well. CUSIP Number is not really important. There are some other columns as well, but these are the main ones we’re interested in.

So, there you have it! Instant stock ideas! Obviously, it goes without saying that you must still further research any investment opportunities before you buy it. Refer to my list of the Top Ten Rules of Value Investing for more on that.


Was this post helpful? Have any further questions regarding hedge funds or investing in general? Let me know in the comments, and be sure to subscribe to the Investing Part Time RSS feed to ensure you get all the upcoming posts!

If you liked this post, check out:

  1. How to Create a Personal Hedge Fund Tracker using Google Reader

How to Create a Personal Hedge Fund Tracker using Google Reader


There are many companies out there, such as AlphaClone, that let you pay a monthly fee in order to get access to their database of hedge fund holdings and “clones,” or model portfolios that track the stocks several prominent funds hold. However, there is no reason why any individual investor with a little bit of free time should have to pay for this service. In this post, you’ll see why: One of the most helpful things about the Securities & Exchange Commission’s EDGAR database is the fact that they let you set up an RSS reader to check for updates (filings) for a specific company whenever they are updated. This is great for non-professional investors with no subscription to Bloomberg Professional, since it is free and easy to set up. You can use whatever RSS reader you’d like, but Google Reader is our preference. Once you have a reader ready to go, following your favorite company or fund is quite easy. In this post, we’ll assume you want to follow some hedge funds.

1. Go to the SEC EDGAR Search page, using this link. Getting to this page via the main site is a bit confusing. The screen you’re looking at should look something like this:

2. From the EDGAR search page, enter the name of the fund or fund manager (in some cases, the two are one in the same). The next step is sometimes challenging. If you’re lucky, there will only be two or three search results, so you can click on each to see which one is most regularly updated. Due to the structure of some of the larger hedge funds (i.e. some of them are registered offshore, or they have a separate management company and the funds are all treated as individual companies), there may be multiple entries. One example of this is Pershing Square Capital Management:

The manager, Bill Ackman, is one of the most widely followed managers. He recently took an activist stake in JCPenney and Fortune Brands (which distributes brands like Titleist, Jim Beam, and Moen), a move which has been widely analyzed since. In fact, following the announcement of moves like this of big hedge fund managers, the stocks involved will usually trade up quite a bit. Any investment by Warren Buffett in the past decade has exhibited this.

3. If you find yourself in a case where there are multiple companies to check, you may have to click into each one. Always look for the “company” with the most recent filings. In the above case, most of the shell companies called Pershing Square often only have one or two documents filed in their name. The reasons why this is the case are beyond the scope of this post. Regardless, even if the fund is not very big, it will still file quarterly reports known as 13F-NTs, which show the long and short equity positions that the fund held at the end of that quarter. These are especially useful when tracking value funds, since the managers like to hold positions for a long time. Even if you buy a stock right after the 13F-NTs are released, you still might gain a decent upside with some of their positions.

4. The final (and easiest) step is to start following them. Hit the RSS icon above the search results on the left side of the page:

5. Repeat steps 1-4 for all the hedge funds and/or companies you would like to follow. We do this for companies that we own, since it is a much easier way to catch press releases and earnings statements than waiting for it to come in the mail or read about it on the Wall Street Journal. If you get in the habit of checking Google Reader every day, then you can always see when something new is filed. The sidebar in Google Reader will then look something like this:

Feel free to find some of those names yourself! No other names come to mind? Check out this list from MarketFolly. A side note: avoid some of the well-known high frequency trading firms, such as Renaissance Technologies, SAC Capital, or D.E. Shaw. They might move in and out of positions too rapidly for any tracking mechanism to be useful. Look for some long-term value investors. Activist investors (such as Ackman) are also good since they try to create catalysts at the company to boost value to shareholders.

If you are interested in learning more about hedge funds, be sure to bookmark or subscribe to Market Folly. We have no affiliation to them, but it is one of our favorite blogs. They post an incredibly useful “What We’re Reading” column each week (see example) that aggregates some of the best articles and stories that week. All of the articles are generally pretty good, and it will also give you a much bigger list of investing blogs to follow.


Thanks for reading! Was this post helpful? Let us know in the comments, and be sure to add us to your RSS reader as well!

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