Stop Your Losses
Stockscores.com Perspectives for the week ending July 16, 2006
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In this week's issue:
One of the great failings of investors and traders is the inability to minimize losses. Even a trader who is right most of the time can suffer unprofitable trading if their losses are larger than their gains. To take out the emotional factors that cause many people to avoid selling their losers, I recommend the use of Stop Loss orders. However, using these orders is not without issues.
First, a Stop Loss order is one that is automatically executed by the brokerage when a price threshold is hit. For example, if you buy 1000 shares of Broadcom (BRCM) at $43.10 and set a Stop Loss Market order at $42.90, then you will be sold out of your position if the stock trades at $42.90. The order will be filled at the best price that prevails in the market at that moment, meaning that you may get a fill on your sell order at a lower price. If you choose to use a Stop Loss Limit order, you will get filled at no worse than the limit price set, but you may not get filled on the order if the stock does not trade at or above your limit price.
I am often asked about the odd priced trades that can sometimes go through in a market, particularly on the Nasdaq, and whether these will trigger a stop loss order. For example, if BRCM is trading at $43 with a bid of $42.99 and an offer of $43.00 but for some reason a trade of 100 shares goes through at $42.80, will that trigger the stop loss order at $42.90? The answer is no, the brokerage's computer systems are programmed to only execute a sell order if the stock not only trades at or below the stop loss price and if that price is inside the bid - ask spread.
Of course, Stop Loss orders can also be used for protection on Short sales except that these orders will buy in and cover the position if an upper threshold is surpassed.
The first question that must be answered is about the price to set the stop loss order at. Many "experts" advise that stops should be limited on a percentage basis like limiting losses to 10% of the trading position. However, this approach makes little sense.
Every stock has its own volatility. To apply a percentage rule across all stocks won't work because a 10% pull back in a stock like Microsoft could take six months but in a hot technology stock, the same move could happen in a matter of hours. Instead, stops must be set based on price thresholds established by trading activity. I like to set stops based on technical support prices that can be seen on the stock chart. If I am day trading, I look for support on intraday charts and if I am position trading, then I establish support based on the daily charts.
Suppose a stock has support at $43.00. Should support be set there? The answer is no, because markets need some room to move. I always set my stops a little below the support price that I see on the stock chart to avoid that frustrating exit just as the stock bounces off of support. Another thing to consider is the emotional barriers that the market establishes. Always put your stop on the other side of a round number. If support is at $42.90, set the stop at $42.89. Most people enter their orders at round numbers which builds a barrier at these prices that can save you from being stopped out.
What is of critical importance in using Stop Loss orders is in understanding the effect of liquidity. Liquidity describes how often the stock trades. Microsoft is much more liquid than Captiva Software because it trades a lot more actively. This means there is less of spread between the bid and ask prices which reduces the likelihood that you will be stopped out of a position only to watch it go higher right after you exit.
As a general rule, the more liquid a stock is, the better Stop Loss orders will work. When I am day trading very active stocks, I will use tight stops. When I am position trading, I tend not to use intraday stop loss orders at all; only considering the closing price as a Stop Loss trigger.
What I mean is that I don't enter a Stop Loss order when I am position trading (longer term trading over weeks or months). Instead, I establish my support price and plan to exit the stock if it closes below the stop loss price.
What can happen is that a stock will go through the stop loss price intraday but then bounce back to close above it before the close. Based on what you see on the daily chart, this stock is still a valid hold because it has not closed below support and therefore there is not yet a message of pessimism in the market.
Stop Loss orders are most useful because they take the emotion out of the painful decision to sell a loser. Using them on liquid stocks is relatively straight forward but their use on less liquid stocks can be frustrated because of the "air pockets" that can occur in a stock's market during the trading day. By being smart about where you set your stop and how you execute the order, you can benefit by limiting downside and avoiding the performance crushing losses that can outweigh many gains.
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Slow summer trading combined with violence in the Middle East meant that stocks went sharply lower this week. It is hard to motivate buyers to act when there is political uncertainty and sellers are inevitable in that environment. So what do you do in a market like this? Since stocks are generally going down in price it might seem smart to short sell stocks. However, the problem is that the drop in prices is related to an abnormal event in a relatively illiquid market condition. Therefore, the market could bounce back very quickly if political conditions change. That means it would be easy to get whipsawed out of short positions.
What the uncertainty in the market means is that there is and will be volatility but where the market goes is difficult to predict. My advice, then, is to do nothing. There is nothing wrong with sitting on cash when the probability of success is not good. There is no need to chase marginal opportunities, wait for conditions to improve.
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References
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Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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