Stop Loss Discussion
Thanks to Jonathan Burton of MarketWatch for including some quotes from me in today’s WSJ article on stop losses. Jonathan brings forth some interesting discussion regarding the use of stop loss orders, so be sure to check out his article.
Click to visit WSJ articleI’ve discussed the subject of using the stop loss order here before, and it’s one habit that I think is imperative for traders who care anything about consistent results and capital preservation.
Some additional comments on stops:
* A stop loss is your emergency exit, your safety net, your plan B when things don’t work out quite like you had planned.
* Even if you’ve never been taught how to set stops or an approach to determining which levels could serve as locations for your stops, choosing an arbitrary price to set your stop is better than not having one at all. Deciding on stop loss levels will largely depend on a couple of factors: the individual stock in question’s personality, and the overall market’s behavior at that time. Taking those into consideration should help you gauge an appropriate spot for an exit, which also is related to position sizing.
* Capital preservation is a priority to traders, but even longer-term investors would be better off incorporating some risk management elements into their plan. It all boils down to respecting the market and setting that ego aside. Your need to be “correct” can become costly if you allow it. So respect the market, or it will force you to respect it! We have to accept some level of risk in order to profit in the market, but even a small measure of humility should be a part of the plan because your timing may be off.
* Consider setting multiple stops for a longer-term position so that you won’t get shaken out on a small dip but at worst you’ll be reducing your position size as the stock moves against you. Your final stop would be in an area that on the chart it’s clear the entire trade has reversed course. Partial sales offer a lot of freedom, so remember that you don’t have to be “all in” or “all out” of a position. Scale out appropriately to reduce risk when you see fit.
* You don’t have to win on every trade, so look at stop loss orders as a way to protect your long term odds of success. Give yourself the best chance of profiting over time by preventing big hits to your account. You want to avoid ever going from stockholder to STUCKholder! Getting deep in the hole on any trade or investment costs you opportunity elsewhere, along with costing you your objectivity. All of us are wrong from time to time in the market, but the best traders know how to limit the damage done when they are wrong. The stop loss allows you to emulate that trait.
* Today’s commission rates are low enough that it’s sensible to use stops and then re-enter the stock later if you see fit. Stated otherwise, it’s easy to reverse that sale and quite inexpensive to do so.
* Every broker offers at least a basic stop loss order, with many brokers (including mine) now offering advanced order types which let you specify multiple conditions that must be met before your stop order gets triggered. That’s a huge tool for today’s traders and investors, so use conditional orders if they’re available to you.
The bottom line is this: small losses are the key to long-term success, whether you’re an investor or a trader. The stop loss order exists for the very purpose of limiting your “wrongs,” so use them!
Jeff White
President, The Stock Bandit, Inc.
Swing Trading & Day Trading Service
www.TheStockBandit.com
[tags]Stock Market, Day Trading, Stock Trading, Swing Trading, Stop Loss, Investing[/tags]
John Forman | Apr 21, 2008 | Reply
While I generally understand the point you’re making with “…choosing an arbitrary price to set your stop is better than not having one at all” it makes me a wee bit nervous being included in a discussion for new traders. If you included the word “loose” I’d feel better because one of the most frequent causes of loss among new traders is setting their stops much too close to the market. They think that reduces their risk when in fact it increases it because they end up taking that loss more frequently.
TheStockBandit | Apr 21, 2008 | Reply
Hey John,
Good to see you here and thanks for the comment. I think you’re right in that many new traders tend to put stops too tight, but upon further review of my phrasing compared to yours (“arbitrary” vs. “loose”), to be honest, neither one offers anything specific. Stated otherwise, a new trader does not know what a “loose” stop is.
We could probably agree that selecting an arbitrary level down lower on the daily chart would be better than having no stop at all. I probably should have phrased it that way.
Hope this clarifies!
Jeff
Wilson | Apr 22, 2008 | Reply
Hi Jeff,
Our group recently wrote a research paper investigating the impact of the stop-loss on expected return and volatility in various market conditions. In it we identify and discuss the hidden costs as well as the perceived benefits of the stop-loss, profit-taking stops, as well as combinations of the two. Robert Macrae wrote in an article in the AIMA journal a few years ago that looked at hidden costs of the stoploss as well. Rather than increased volatility caused by using leverage to maintain the same exposure, we find that the hidden costs are actually opportunity costs necessarily caused by the impact of the stop loss on the return distribution. Volatility reduction was also found at the position-level.
Based on our findings, stop-loss use must be conditional on the type of strategy used as well as the overall market condition. For example, in a sustained bull market, having a -10% stop-loss actually reduces your probability of having a positive 5% return! In general I think for the average (passive) investor it is probably a good idea to have stops out, since they do reduce volatility, but if one is seeking to maximize returns then understanding the mechanics of the stop-loss is essential in incorporating it into an active trading strategy.
Abstract:
In this paper, we present general implications of the impact of stop-losses to future returns. The use of stop-losses change return distributions, but not in the way that one would typically expect. We find that while stop-losses can reduce position volatility, hidden costs offset perceived benefits in terms of altering future returns. Use of both stop-losses and profit-taking stops separately or in conjunction offer no statistically significant difference in expected return but have a meaningful impact in returns with drift, as the expected return converges to that of the underlying.
Blog post:
http://advanceyourfinance.blogspot.com/2008/03/re-examining-hidden-costs-of-stoploss.html
Macrae’s original article:
http://www.aima.org/uploads/Arcus66.pdf
The paper:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1123362
I hope some of your readers will find this of value.
-Wilson
TheStockBandit | Apr 23, 2008 | Reply
Hey Wilson,
Thanks for stopping by and for posting this info on your research. I completely agree that the conditions surrounding one’s stop loss should be determined by the strategy being used. As you mentioned, the overall market should have a big influence on how, where and why you’re placing your stops.
Good stuff and thanks for sharing!
Jeff
Trading System Reviews | May 13, 2008 | Reply
I have found stop losses to be a double edged sword. While they do take you out of a position at a predetermined point they also make you vulnerable to volatility, some of it random, some of it manufactured just to take out your stops! Even if you do not set them too tight to the price initially, it does not take much of a drop in price to make it tight, then you are going to get taken out by even a small downward spike. This is especially true when market conditions are getting more volatile – when it gets volatile you often find the opening and closing prices are not far apart, but the intra-day prices certainly are. Beyond that I totally agree with the sentiment here, you must understand the conditions under which you sell under your system – whether you do it yourself or via stops is down to the system.
Also, going back to an earlier point that was made about new traders not knowing how to set stops. When I have spoken to people looking to get into the markets all they want to talk about is ‘what should I buy?’ It always takes me an age to explain that you can set up a system using a random entry and make money in the long term with good risk management and exits in place so the entry is actually the least important element. You then have to explain there are very profitable systems where only one trade in five is profitable, but the profitable ones are HUGE and others where you can win 99% of the time, but end up with nothing as one of those losers can take everything (just ask Societe General or Barings about that!) The mechanism by which your system works will help you determine your exits, risk management…by this point most people are looking a bit dumbfounded so I usually find I’m talking to myself about the risk management, position sizing and the mental toughness
TheStockBandit | May 14, 2008 | Reply
TSR,
Thanks for your comments here, you bring up some excellent points. I think that a hard stop is particularly best for those who lack the discipline to pull the trigger in the heat of battle. But you’re correct, knowing when to get out is the most important aspect here.
It is funny how the money management topic tends to lose some people and you get that glazed-eye look when you start to discuss it, but you’re absolutely right in that several small losses are easily covered by the occasional big win. I think of a good poker player folding, folding, folding and then winning a nice sized pot, so that’s the analogy I’ve used most frequently. I have also seen traders with that 99% win rate who, oddly enough, are no longer trading 😉
Trade well today and thanks for your comments!
Jeff