Why Retailers Get Stopped Out In Mining Stocks

Q: How do you think about setting stop losses for mining stocks? I hear suggestions like 10%, 20%, 30%, even 50%. I am quite confused as how to set a stop loss, because I always get stopped out whenever I do a 10% stop loss.

A: Many times you hear investors use stop loses of 10% or 30%? Why? This is because they heard someone else use it, or they just make it up! Many investors, both retail and professional investors, don’t understand the personality that each stock has, otherwise known as the volatility in the stock. Arbitrarily, they pull up a chart, and they see there hasn’t been any major drop in the past few years, and assume after eyeballing the chart, the stock has low volatility. While it maybe true in the short-term, the data may not support this, particularly over a 5-10 year period.

Let’s Look at 3 Commodity Companies

1. WPM – Wheaton Precious Metals, the largest silver streaming company in the world

2. ABX – Barrick Gold, the largest gold mining company in the world

3. NGD – New Gold, mid-tier gold producer

Commonalities:

1. They all have exposure to gold

2. They all are listed on the NYSE

3. They all went through the 2008 recession

What Stop Loss Would You Apply To Wheaton Precious Metals?

Many will pick 10%, 15%, some may pick 30%, maybe 5%? Looking at the chart below will only tell you a portion as to how professional traders and portfolio managers can evaluate setting a stop loss.

What Stop Loss would you set for Barrick Gold?

What Stop Loss would you set for New Gold?

So What’s Missing?

Investors need to know the average true range. Say what? It’s what professional traders apply to cut their losses faster, when they get their thesis incorrect.

“Average true range (ATR) is a technical analysis volatility indicator originally developed by J. Welles Wilder, Jr. for commodities. The indicator does not provide an indication of price trend; simply the degree of price volatility Current ATR value (or a multiple of it) can be used as the size of the potential adverse movement (stop-loss distance) when calculating the trade volume based on trader's risk tolerance. In this case, ATR provides a self-adjusting risk limit dependent on the market volatility for strategies without a fixed stop-loss placement. A less volatile market has a larger trading position in comparison to a more volatile market in a portfolio.”[1]

Surprisingly most investors in the mining sector don’t apply this approach. It’s shocking! I think maybe, because most just are never exposed to it. This is why we thought it would be helpful for you to see.

Why apply an ATR?

"Letting your emotions override your plan or system is the biggest cause of failure." J. Welles Wilder

When you go into a trade, professionals ask 2 questions, how much can you make, and what is the most you can lose? If you make an investment for $5,000 and the most you are wiling to lose is $2,500. You are setting a stop loss at 50%. But does that really match the personality of the stock?

Not willing to cut?

Most investors let their losers stick around for 2-3 years, and cut their winners if they are up 30%-50%. The challenge is to keep hustling by identifying new trades to keep your portfolio fresh, while letting your winners run, and replacing your losers. In order to make the true multi-bagger approach, you have to hold-on. This is the hardest part of investing, holding on when you are correct, and cutting it when you are wrong. The truth is, most investors do not have time to find stocks every week or every month. This is why ETF’s have become more popular.

Why do professionals apply an ATR?

If the company has an ATR of 50% on a monthly basis over a 10-year period, this would imply the stock has a lot volatility. One could see the price have a range of 50% between the high and the low in relation to the open. If the stock has a position size of 20-30% in your portfolio, is it worth it to have monthly volatility of 50%? Professional money managers may tuck it away in a 1-2% position weighting instead because it won’t move around the portfolio. Volatility is loved by Traders and hated by Portfolio Managers. What if the volatility is too high for you? Maybe skip this stock and look for another one if you aren’t 100% confident in it. There are 1000’s of stocks to choose from. Professional investors are wiling to keep looking.

What is the ATR for WPM?

On a daily basis, volatility has come down from 4.3% over the past 10 years, but the 10 year period is taking into consideration the 2008 recession and the rise and fall of silver from the peak.

On a monthly basis, volatility is quite volatile in the stock over a 12 month (29.53%) and 10 year (30.99%) period. The monthly ATR shows that it is quite possible even with a 30% or 40% stop loss, you could get pushed out of the security, when you may want to stay into the position.

What is the ATR for ABX?

Barrick Gold is showing that volatility on a daily basis has fallen over the past three years from 3.71% to 1.65%, as it was going through restructuring and a bottom in the gold price.

You can see on a monthly volatility, Barrick has an ATR of 28.36% on 1 year. A stop loss of 10% wouldn’t work for even for Barrick, the biggest gold mining company in the world.

What is the ATR for NGD?

Owning New Gold, and setting a 10% stop loss, just won’t work in this case, because the chance of you getting stopped out on a monthly basis, are quite high, always being above 15% over a 10 year period. All the work you did identifying the opportunity, and then you are pushed out of your position before you are able to see your thesis be proven correct or not.

What do the ATR’s of the three companies tell us?

Setting random stop losses at 10% or 20% aren’t very helpful. All stocks have their own unique personalities that investors need to know how the stock reacts. Know how much you are wiling to lose and match it with the ATR, otherwise you will be stopped out of your position. Professionals want to know the ATR, because it mentally helps prepare you as to what will happen to the stock in normal trading, so you aren’t surprised.

*********

Paul Farrugia, BCom. Paul is the President & CEO of First Macro Capital. He helps his readers identify mining stocks that can you can hold for the long-term. He provides a checklist to find winning mining producer stocks.

Source: [1] Wikipedia