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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