Monday, June 04, 2012

Logica, and the use of guaranteed stops

Earlier this year I was long UK stock Logica CMG, and profited from the uptrend that ran until I was stopped out in early April. This then quickly reverted to a possible short position, and although I did not trade the short, it was generating a nice profit, until late last week when a possible takover was announced, which sent the share price soaring. As the chart below shows, this created a massive gap up through the intended trailing stop level, surpassing the intial entry price and even that of the intial stop level, which would have resulted in a loss larger than the original amount risked.

These kind of events can cause significant damage to a trader's equity if robust controls, along with sensible position sizing, are not in place.

I risk 2% of my current equity on each trade, which some people may regard as an agresssive level. However, as my trading is carried out using spreadbetting via IG Index, I would have avoided such an event as on all my positions I use the 'controlled risk' option which acts as a guaranteed stop level. This means that, in the event of a significant gap like that as seen on the Logica chart, my stop level is adhered to and I am stopped out at that level. In this particular example, this would have still enable saved me the majority of the profits earned on the short trade. Some points to note regarding the guaranteed stop facility:
  • Guaranteed stops are not available on all stocks - if they are not available, I do not trade that stock;
  • The stops have to be placed a minimum distance away from the current market price (e.g. for the majority of US stocks that arev available to trade, the minium stop distance is 10% of the current market price);
  • There is a small premium to pay when opening a position, which is paid for via a small adjustment to the entry price.
Although this may slightly limit the number of possible trading opportunities available to me, I have the peace of mind that I can never lose more than 1R (or 2% of my equity) on an individual trade as a result of a gap or slippage through my stop levels.

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