Friday, January 21, 2011

More Thoughts on Stops

One subject that always seems to generate interest and comments is the stop loss order. One contingent contends that they do not and will not use stop loss orders because they might get stopped out of a position only to see it reverse and take off in the direction they originally wanted. Members of that group often cite specific situations where exactly that scenario unfolded and they missed a good trade. Sometimes they argue that market makers manipulate the stock to accomplish just that result.

Those favoring the other side of the argument contend that placing a stop loss order is a way to limit losses without relying on that little inner voice that says: "It'll come back." This group argues that if they are stopped out of a position and it reverses they can re-enter the position.

I fall into the latter group and believe that stop loss orders are worthwhile devices that can be used to enhance trading and investing results. The first rule of successful trading is to cut losses. When asked how to make money in the stock market, legendary investor, Warren Buffett, reputedly said: "Don't lose." Certainly that is great advice and the question becomes how can one avoid or at least limit losses.

Clearly, one way to limit losses is to place a stop loss order. It gets us out of a position that is going the wrong way. What other way might a trader or investor use to cut a loss? Of course, one way would be to listen to that little voice inside our head. One investor recently said that he relies on a "little neuron" to tell him when to get out. In my work with traders and my own coaching students I find that the "little voice" or "neuron" approach can lead to very significant losses just as the "it'll come back" argument often does. Actually some losing positions may and do come back, but it seems to me that an important and unanswerable question is: "When?"

Sometimes positions never come back. Remember Lehman Brothers and Bear Stearns? How about Enron or WorldCom? Stocks disappear all the time and, of course, never come back. How is one reliably able to predict whether his falling stock will ever come back and if it does how long will that take? As a position falls, the investor not only is losing money, he is also losing time and the opportunity to place his money in something else that is currently going the right way.

As we remember that a stock that falls 50% must then climb 100% just to break even we may see the wisdom of cutting a loss relatively early. 100% moves occur but it often takes quite a long time for that to occur and instead of suffering through the losing period and the following recovery period without knowing whether or when the recovery will be complete might we not be better off having cut the loss early and moved to another more positive appearing play?

While failing, refusing, or deciding not to set a stop loss order might not mean that the trader or investor has no exit strategy, my experience with traders suggests it often means exactly that and the failure to have an exit strategy can lead to very significant losses. I recall writing an article some years ago where I made a similar suggestion that anyone, whether they consider themselves trader or investor, should have an exit strategy. I argued that the literal "buy and hold" approach is marvelous for heirs since the exit strategy is death, but anyone who has any expectancy of closing a position other than at their death should have an exit strategy and might consider using a stop loss order. An irate buy and hold reader responded and suggested he, not I, should be writing these articles since buy and hold was the only intelligent approach to investing. He cited Citigroup (C) as an example of his brilliance as a buy and hold strategist. In 2006, Citigroup (C) hit $57 a share. As I write this article in January, 2011 it is trading below $5 a share. Is it coming back? Maybe? When? Absolutely no one knows.

Would it have been better to have exited C with a stop loss several years ago or to have hung on until today? How you trade and what you do is certainly your business because it is your money. For my own money I prefer to employ a strategy that will get me out when a play is going the wrong way and, for me, I find that a stop loss order is a good way to discipline my exits. Please note that I did not write that it is the only way, your way may be different and quite successful. I just know that many with whom I have come in contact over the years have refused to use stops and have paid a very dear price.

by Bill Kraft, Editor
Copyright 2011, Makin' Hay, Inc.
All Rights Reserved


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24 comments:

Anonymous said...

I subscribe to your belief in setting stop losses. However, If you are an active trader you should remember that the IRS now enforces the wash sale rule and since Jan.1, 2011, brokerage houses will now enforce and recalculate your cost basis on any re-entry transaction if you decide to get back into a stock at a lower price. They now have the software to calculate this and will report accordingly in 2011. This was not reported this way last year, but the IRS was losing too much tax revenue, thus forced the on-line brokerage houses to install the appropriate software. So watch your new cost basis.

George S. said...

I totally agree. Admit you were wrong and live to fight another day. Buy and hold your winners.

Anonymous said...

I am sixty seven years old. My friends and I invest/trade for fun and profit. On stop losses, some in our group argue that setting a close trailing stop is a good way to sell a position. If it suddenly moves up you get the profit and if it moves down you are out with a small loss. I think, should you be ready to sell, sell and move one. Having the cash ready for the next play is better then waiting.
Your thoughts ????

Anonymous said...

My problem is not whether to set a stop, but how to determine where precisely it should be set - down 5%, 10%, 20& or more - for best economic result.

Anonymous said...

Hi Bill--
When I get into a trade, I am glued to the PC screen watching the movement of the trade until I get out. Given that I watch the movement of the stock constantly, and therefore can tell when it is going against me and decide whether to immediately get out, is a Stop Loss that important for my situation? Thanks for all your work in educating us. John W., Laurel, MD

SUJIT said...

You make a very forceful argument Bill which no sane person can deny.

I for one, do believe that with stops we all expose ourselves to these HST sharks - ethics at Wall Street, well that's a whole new subject.

I watch the prices at least every hour on the hour and make my decision in real time, and yes, that still makes my trades vulnerable though not as much as your buy-and-hold-C person. Admittedly, I am still a novice at determining where to place the stops. I have tried every trick I have read in books but to little avail. I invariably look like a fool after getting stopped out.

One final thought: I will NEVER buy and hold (and forget in the lockbox as they would want you to do). Now I know some will immediately cite the great Warren Buffet. To them I say, let's get real, we don't have the information Mr Buffet has, and of course the combined understanding of that legend and his army of analysts. So if we get information from public domain, buy yourself an insurance before you to buy-and-hold.

Thank you Bill for taking the time.

Sujit Sanyal

Ahmad said...

If you don't have a stop-loss order then your money is dead while waiting for the stock to come back up.

Bill Kraft, MarketFN.com said...

Great point on the wash rule, Anonymous. Nevertheless, I don't mind a re-entry if I have cut a loss well and have a good re-entry point with a nearby exit. Thanks,
Bill Kraft

Bill Kraft, MarketFN.com said...

Amen, George S. Thanks for writing.
Bill Kraft

Bill Kraft, MarketFN.com said...

I'm 67, too, Anonymous. I usually wait until I'm profitable to use a trailing stop but before that often follow candlesticks up on bullish trades.
Bill Kraft

Bill Kraft, MarketFN.com said...

I agree, Anonymous, where to set the stop is the most difficult part. I often use candlesticks.
Bill Kraft

Bill Kraft, MarketFN.com said...

Well, Dr. Laurel, if you are glued to the screen I suspect a stop may not be as necessary AS LONG AS you have a predetermined exit strategy AND FOLLOW IT. There are many times, however, when I want to be away from the computer. Let's not forget there is more to life.
Bill Kraft

Bill Kraft, MarketFN.com said...

Sujit, we definitely are on the same page on this one. Placing good to great stops seems only to come with experience and I'm still gaining that. I suspect the learning never ends.
Bill Kraft

Bill Kraft, MarketFN.com said...

That's for sure, Ahmad. Thanks for writing.
Bill Kraft

Anonymous said...

Bill,

I agree with the person who sets his stop when it becomes profitable with the situation where you are sitting at the computer on a trade that just received positive news and it is running up. I keeping moving the stop up manualy as it rises rather than a set stop since I want to follow it closely. This seems to work pretty well on a short trade "run-up" that usually returns close to where it was at opening. I totally agree that a stop should be used on any trade that you are not babysitting, for sure. I have saved many dollars using a stop and I see the value in it. Getting stopped out seems to happen no matter how careful you are. If you set the stop too far away, you just lose that much more. I like to "get in for a run up" and get back out. Although, recently I missed a large gain due to jumping out early when it reversed and not getting back in. I am sad to say it was a $30,000 dollar miss. On the other hand, I have saved that much from using stops. Last year I made 71% on my portfolio just on "run-ups".
Trade on.....

Jamie

Sailor Jo said...

Stops definitely have their place in trading. What bothers me is that various brokerages have all kind of software to determine and execute the stops. I use a broker who has fairly primitive stops, either a price or a percentage as trigger. But I cannot set end of day price or sell only above a limit.

I was recently stopped out of a stock where I used an 8% stop. But once it was sold I was down 15%. It was a flash dip and the stock continued higher. In my case I bought the stock back another 10% cheaper and I am up again. Now I only use a mental stop for that specific stock.

Anonymous said...

As a day trader I am a firm believer in stops. My last 10 trades were losers so I stopped trading for 60 days - all as a result of stops. However, the sum total of my loses was less than $500 on $200,000 worth of trades. Had I bought and held the issue I was day trading I would now be down 30% on my full $100,000 portfolio. The sustained series of loses forced me to step back and revisit my issue choice and trading strategy. In retrospect, it was a very inexpensive wake up call. I trade volatile issues like 3X ETFs. They often move 5 percent in a single day. I find that I MUST set stops to protect myself from unreliable network connections.

Anonymous said...

Bill, Whats with the "flash dips" Sailor Jo mentioned and I'm seeing more of? Looks to me like someone has an unfair (illegal?) advantage here.

Bill Kraft, MarketFN.com said...

Well done, Jamie! I agree with moving stops up manually as one is watching a position. All too often inexperienced traders just watch and even if they have an exit strategy in mind fail to fulfill it as a position turns. The stop takes away the hesitance to do what they planned to do in the first place.
Bill Kraft

Bill Kraft, MarketFN.com said...

Thanks for your comments, Sailor Jo. You raise a very important point about brokerage firms. The type of orders available as well as how they are executed is extremely important. In my experience if the brokerage firm doesn't offer what I want and need it is time to change brokers. Good fills can make up a lot of commissions.
Bill Kraft

Bill Kraft, MarketFN.com said...

What a great contribution, Anonymous the day trader. Congratulations on pulling back from your trading after a series of losses and even heartier congratulations on keeping those losses minimal. Sounds like you know what you are doing.
Bill Kraft

Bill Kraft, MarketFN.com said...

I don't know the answer to the flash dip issue. It certainly seems like there might be some unfair and illegal manipulation going on there.
Bill Kraft

Anonymous said...

Hi Bill,
As always, a valuable reminder on this important step. If I may, I would like to ask you questions: 1). Do you place stop loss in option trading 2). If yo do, can you give a simple example on how you correlate the candlestick prediction with the option stop loss(i.e: not in day trading). Thank you. With warmest regards, Frans.

Bill Kraft, MarketFN.com said...

Thanks for writing, Frans. When I place a stop on a directional option position I generally make the stop one that is contingent upon the price of the stock. Since such an order results in a market order I know I will likely get the short end of the bid ask spread on closing so I do it with options that have significant open interest and a relatively small bid/ ask spread (like 15 cents). An easy candle example would be right after a window (gap) up when I would make my stop to sell the option contingent on the stock price dipping back into the window. Hope that helps.
Bill Kraft