Comments From Part I - Stop Losses Are Protection for investors - A Fallacy

A stop loss is intended to prevent the investor from losing more than an expected amount, but more often than not, a stop loss is instead a guarantee that normal and reoccurring volatility in a stock will trigger the stop loss and as a result the investor will sell when the stock plunges on a temporary basis. A stop loss is supposed to protect you against a continued decline in value by selling the stock when a predetermined loss is reached, but in most cases, that level is just a temporary plunge with an almost instant recovery.

What is also unexpected, is that professionals often cause the plunge in value so that they can trigger your stop loss and then buy your stock at a severely depressed price. In other words, the innocent get fleeced by the pros.

The most damaging effect, and what affects the investor most, is liquidity in a stock. When a stop loss order is triggered, one assumes that there will always be buyers to buy this stock at the price at which the investor is offering to sell the stock. Unfortunately, this is often not the case. Often the reason that a stock falls, is a lack of buyers to buy the stock that the seller wishes to sell by triggering their stop losses, so the effect is - an immediately downward pressure on the price of the stock. This means the price that the investor is offering to sell at, is often higher than the market price at the time the investor wishes to sell. The stop loss is therefore, self-defeating.

A Guaranteed Loss - of Unrestricted Magnitude

Ignoring the other cautions, consider why a stock falls in value. Falls are usually quite dramatic and usually quite sudden. It is rare for a 20% drop in a stock that moves slowly and methodically down 20% in value. It does happen of course, but the probability is that the calm and slow decline in value is less frequently seen that one might think. If this slow and calm drop in value occurs, then stop losses work perfectly. They are ideal in this situation, unless of course you are a long time value investor and are prepared to hold a stock for a long enough period that you ignore the bumps in the road.

What Usually Happens - Selling at Market

Understand what a stop loss is. It is a standing order to sell at "market". That means, that when the price of the stocks falls and hits that preset value, an order to sell is triggered. Usually (with exceptions) that order is an instruction to sell immediately no matter what. So the stock will be sold at whatever price is bid by prospective buyers. Because usually, there are no limits, whoever is offering whatever price will buy your stock. So, conceivably you could be selling for a 20% loss, or a 50% loss, or an 85% loss. Triggering a market order is like digging into your pocket and handing your money to any stranger that happens to be walking by at that moment. You have no say in the matter. The stock is sold to the highest bidder at that moment in time, without restriction.

Essential Protection if You Use Stop Losses

Never, ever, put a stop loss in place without setting limits on how low a price you will accept. This at a minimum ensures that if you do sell the stock, you will only sell it in a price range that you have pre-determined.

Now consider what you are doing. You will sell the stock at a time, and a price, that you have not determined. If the price is falling dramatically, which is usually the case, you will not sell the stock by using a stop loss, because the price will quickly fall through your specified range and as soon as it hits the minimum price that you have specified on its way down, your selling stops. So your protection means that none, or only a bit of your stock was sold. An unintended consequence is that your sell order will put more downward pressure on the price of the stock, causing it to fall farther and faster than it otherwise would.

Conclusion

Using stop loss orders can protect you, but only in a very narrow range of circumstances. Usually using a stop loss order guarantees that you will lose more money than you bargained for.

Your broker may insist that you have to take this risk in order to protect yourself, but reality is that if a stock falls, you still have the opportunity to decide what to do, rather than have a predetermined sell order "at market".

It is an old adage - those that accept advice without doing their own homework, usually pay the price. BUYER BEWARE.

Stop Losses Do Have an Important Use

In futures trading, in commodity trading and in derivative trading, stop losses are essential. This type of trading is not generally used by the value investor, but they comprise a larger part of the market than the value investor. In this type of trading, there is tremendous leverage. Generally one puts only a small amount of the total investment on the line. If the trade turns against the trader. the invested amount can be eaten up in seconds, resulting in margin calls, forced sales, demands for extra cash to be invested, and other very serious consequences.

Stop losses in those types of environments are essential. To fail to have a stop loss in place, is to risk everything on every trade. A bad trade can wipe the trader out.

Because traders constantly buy and sell, they consider that some trades will be losers and some will be winners. Stop losses ensure that the losing trades are ended quickly, whereas the winning trades are allowed to continue to supposedly increase profits. In that environment, stop losses are a valuable tool. An additional feature is that in these tpes of markets, liquidity is almost always high, so that trades are executed promptly,and generally at the price of the stop loss.

The views expressed in this blog are opinions only and are not investment advice. Persons investing should seek the advice of a licensed professional to guide them and should not rely on the opinions expressed herein. This blog is not a solicitation for investment and we do not accept unsolicited investment funds.