Why I hate stop loss orders

September 3, 201813 Comments

I frequently get asked whether we at ValueTrend use “stop loss orders” to limit our downside on a trade gone bad. After all, the tagline for ValueTrend Wealth Management is “Limit your risk. Keep your money”. You’d think that we’d be all over the concept of preventing losses by using stop’s, wouldn’t you? In theory, setting a stop loss on a stock should work to reduce losses. Let’s say you buy a stock at $10, and have a stop loss order sit just under your price –let’s say you want to contain your loss to 10%. So you enter the stop loss order to trigger at  $9 – which theoretically limits your loss to 10%. After all, the trader / the computer has to immediately trigger a sell on the stock if as and when the stock hits $9. If it stays above $9 – you keep the stock, and hopefully realizes its ultimate upside. A perfect world!

Not so fast! I’m going to condense 30 years of trading stocks professionally into one succinct discussion on why I don’t use stop losses. I’ve used them in the past, and learned some valuable lessons. Here is why I’ve learned not to use stop loss orders:

 

There “is” volatility!

Fact is, stocks gap down for negative breaking news, lousy earnings reports, false news, rumors, computerized trading, institutional selling and many other reasons. Let’s say such a news event hits your stock. Suddenly, your stop loss is triggered. But it won’t necessarily be sold at your $9 stop price. Instead, it will be triggered at the next available market price. In a fast moving market, you will often see your stock sold into a knee-jerk overreaction to the news. A few days later, the stock is back to your old price. But you aren’t in it any longer.

To put it bluntly, your stock will very often be automatically sold at the lowest price in such situations.  Instead of limiting your loss to 10%, it may be substantially more. And, you may regret the sale later.

Below is a stop loss failure that might have happened to a short termed trader on Blackberry. Yeah, I know–most of us trade a bit longer termed than this example, but lets just use this for easy illustration. Green arrows mark the trades. The stop was set at $13.00 having bought at $13.80 on a breakout. It triggered with a rapid markdown finishing the day at $12.50 – but I assume the trader got out a dime over that at $12.60. Three weeks later, the trader was found in a bar, drinking heavily. There are hundreds of such failed examples of computer-entered stops you will spot on charts.

 

But wait, there’s more….

 

Beware the dark side of the force

Did you know that when you place a stop loss order, that order is transparent? Market-makers on the stock see your order and often “run the stops”. This occurs when the stock is forced low enough to trigger a large cluster of stop loss orders . Market makers, and other pro’s, know that round numbers or obvious support levels are popular with amateurs using stop loss orders. Computers recognize these retail stop loss patterns and can execute in a heartbeat. Your stock gets popped out with the rest of the less informed investors holding stops at this well represented stop-price.  Then, the stock reverses direction and rallies.

 

Humans still matter

Stop losses are like self-driving cars. Yes, they are convenient, but you are relying on a machine to look after you. Seems that Google and Uber  have discovered that auto-pilot technology is great …. EXCEPT at busy intersections with jaywalking passengers, complex traffic patterns, bicycle traffic, etc.  Yup – humans can outdrive a robot in these conditions.   Similarly, stop losses seem like a good idea…. until the above situations occur, and human judgement would have prevented trading losses.

 

Technical analysis allows us to set mental stop losses. By using my “3 bar rule” per my book Sideways – you will hold the stock for at least 3 days after a support level is breached (or 3 weeks if you have a longer horizon). You are in control. No pro trader is taking advantage of you. No whipsaw news item will sell you out at a deep loss – only to watch the stock rise again.

 

Happy trading!

 

13 Comments

    • Transparent to the market maker, and pretty easy to estimate for the rest of the players.

      Reply
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    ED YARDENI, YARDENI RESEARCH

    ANY COMMENT ON EMERGING MARKET SITUATION?

    Reply
  • Thanks for showing us the trap Keith.

    I wonder why so many pundits say “Be sure to get your stops in.” (??)

    Reply
    • Sometimes they mean “mental” stops – not actual physical stop orders placed in the system. That is my preferred way. I look at technical support, decide a level below that I would sell, then if it busts, wait a minimum of 3 days to see if its just a spike and rebound (maximum 3 weeks, depending on situation) and make the move accordingly. A physical stop doesn’t afford one that time to see if its a spike, per my article.

      Reply
  • Hi Keith. Great discussion. I have found part of the solution to this sort of volatility is to simply buy good companies that we feel comfortable owning. Do not succumb to knee-jerk reactions that will happen. If something fundamental changes in the company then re-evaluate and perhaps sell after the three bars have passed. I do not trade as much as you but watch for significant changes in a company that signal a different trajectory than in the past and will sell in those cases. Keep up the good work.

    Reply
  • Hi Keith, thanks for the article. I started using stops after I lost a whole position in Poseidon Concepts several years back. Perhaps you remember the stock. I use trailing stop limits with the stop at around 15%, and the limit a few percent below that. Twice now, I’ve had a stock gap down so hard that it blew through the stop and the limit and never filled. I then just sold it. A few weeks ago it happened to Ticker BRE. A glance at the chart will show when it happened.As I said, I use trailing stop limits and reset them every month or so. What should I look for on the charts to define “support”. What do you use as a mental stop?

    Thanks,

    Reply
    • Hi Bill
      I define my “stop” point (remember that I do not use physical stops) as about 3% below support. Support is generally defined as a consolidation point of at least 3 successful tests – OR – in an uptrend, the last trough within that trend -and your favorite moving average. So, a break of a trend (given my time horizon) is defined as breaking the last trough on the weekly chart AND a break of the 200 day SMA. If those conditions happen, I sell after a few days and if it’s more than 3% or so of a break.
      Read my book Sideways for greater detail on this–thx

      Reply
    • Sally–per my reply to Christopher’s question–they are transparent, but only to the market makers- who can play those stops as described. However even if they are not transparent to other traders- others can usually estimate with decent accuracy where they are and play into that cluster of stops to your disadvantage…Plus, when stops are hit, it becomes very apparant to the computer programs, who in turn jump on the opportunity to play a panic move.
      Most popular is sell-stops, but I’d expect both sides might be susceptible.

      Reply
  • Interesting article
    Does this transparency allow the market maker to force the price down to the stop price?
    If not then i assume getting stopped out is what is preferred.
    If volatility triggers it then oh well.
    Stops hAve messed up some of my stocks to the penny but i dont want market crashes to ruin everything

    Reply
    • Thanks Mark–its an older post, glad you found it!
      The traders (not market makers) will make certain assumptions that round prices and support levels will have stops set at or below them. So they will attempt to play that likelyhood by pushing prices down. Or just buy into the assumed stop levels for a quick rebound when the stop prices (selling pressure) disappears. Again, its why I use a few days to determine if its a head fake or not. In other words, I use a stop loss, but its not a physical order put into the system. I put a reminder on my stock tracking screen to alert me if a level is broken, then if it is, I wait 3 days+ to react, and watch the pattern. Like I note, the auto-driving car can sometimes operate worse than the human driver’s judgement in complex situations.

      Reply

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