Capital Loss and Stop Loss – Defining risk appetite?
Stop loss limits
Stop loss limits act as a safety valve in case something starts to go wrong. Stop loss limits state that specified action must take place if the loss exceeds a threshold amount. Tight stop loss limits reduce the maximum possible loss and therefore reduce the capital required for the business. However, if the limits are too tight they reduce the trader’s ability to make a profit.
The first step in setting stop loss limits is to determine the appetite of the company regarding its risk tolerance. This translates to specifying the amount of capital that the company can afford to lose.
The following elements would need to be considered when determining the capital loss amount.
- The expected rate of return that will be earned on the capital will the next twelve month period.
- The minimum acceptable rate of return that will be required to satisfy shareholders.
In no situation should the capital loss amount eat into eat into principal capital amount or in other words the rate of return required should never be negative.
This is elaborated in the following example:
|Rate of return expected||6% p.a.|
|Expected return||USD 60,000,000|
|Minimum acceptable rate of return||2% p.a.|
|Return required||USD 20,000,000|
|Capital loss amount||USD 40,000,000|
The next step in this process is to specify a target stop loss limit. The stop loss limits give us the amount of money that a portfolios’ single-period market loss should not exceed.
This limit together will the capital loss amount will be used in determining the book size of the company. Using the example above the target stop loss limits is set at 10%. This implies that the capital loss amount is equal to 10% of the book size or alternatively the book size is the capital loss amount divided by 10%. This would mean that the book size will be 20,000,000 ÷ 0.10 or 200,000,000. It may be noted that this assumes that the company has the perfect ability to liquidate assets at the optimal level if the stop loss limit is activated.
After the target stop loss limit has been defined, and the book size determined, the amount will be allocated to individual investment lines and the stop loss limits will be set at the individual asset level.
These actual stop loss limits implemented at individual levels will have to be lower than the target stop loss limit to account for slippage, i.e. instances when the company would not be able to liquidate the position at a price for which the stop loss limit is exactly met. We recommend actual stop loss limits 1% – 2% less than the target stop loss limit depending on the daily movement in a specific market.
This is illustrated below. We assume that the book size of 500,000,000 is allocated among 10 lines of investment (positions) equally and that the entire allocated amount is utilized so that the allocated amount is equal to the book value of the investment. While the internal stop loss limit is set at 10%, the actual hard stop loss limit is set at 8% to provide room for 2% of slippage and is supported by 40,000,000 of stop loss capital.
|Lines of Investment||Allocated Amount /|
|Purchase Price||Quantity||Stop Loss||Stop Loss Amount||MTM||Market Value||Gain / Loss||Stop Loss decision|
Expected Capital Loss @ Stop Loss = 40,000,000
Rate of return adjusted for expected capital loss = 6% – (40,000,000÷1,000,000,000) = 2%
Slippage or the reason for having the actual stop loss limit at a level lower than the target is illustrated below. The example assumes that all MTM prices are lower than 10% from those given above. If the actual stop loss limit is breached then the investment can only be liquidated at MTM (revised) = MTM × (1-10%):
|Lines of Investment||MTM (revised)||Market Value||Gain/Loss||Stop Loss decision||Loss if exceeding Stop Loss||% of BV|
Slippage/ Excess Loss