Thursday, February 09, 2006


The wisdom of stop loss orders

I had a limit order in place this morning to sell 2500 shares of SMTX. Although the order came close to being filled in the AM, by the afternoon, the stock had fizzled with the rest of the market. Still, most of my biggest positions managed to stay in the plus column today, and I finished the day up $900.

I reader asks:

do you ever use stops instead of selling outright? Sure, if your guess on the direction of the stock is correct, this will result in lower profits. But if you are wrong, and the stock keeps moving in the right direction, you profit. It seems to me, with tight enough stops, this could be more profitable than just selling.

My view on stop loss orders is that you need to know when to use them. You can trade in two ways: you can trade based on technicals (price movements, volume, etc.) or you can trade based on fundamentals (earnings, asset and liability values, sales growth, etc.). If you trade based on the fundamentals (the fundies) like I do, stop loss orders make no sense. After all, my aim is to buy a stock that I regard as cheap relative to its fundamentals. If the stock goes down after I buy it, then it gets cheaper and more attractive, not less. On the other hand, if you're trading based on the technicals, you should set a stop loss at the point where you believe the stock is no longer worth owning based on its technical merits.

What type of trading you do depends on your preferences, your personality, and your circumstances. For me, I prefer to trade the fundies because I think that is where my edge is (quite frankly, I'm a lousy technical trader). Besides, when you are away from the computer for the vast majority of the day and sometimes days on end like I am, trading the fundamentals is the only viable option.

Automatic stop losses should never be used on the type of illiquid low volume stocks in your portfolio. For these types of stocks, stop loss orders are an invitation for the market maker to plunge the market long enough to scoop up your shares, at a time of his choosing when your stop losses are setting there for him to take without a lot of buys in the vicinity. Stop loss orders can make sense for liquid stocks when you can't watch the market continuously.
The other problem with stop loss orders is that they become market orders when they activate which can lead to surprises when you're trading in small thinly-traded stocks... as I found out recently.

Of course, you can use stop-limit orders to protect yourself, but I think Stockcoach's advice is better.
Hey coach.. I was the reader you were responding to.

My question wasn't so much about stopping your losses .. I understand about the stock being MORE attractive as it goes down (to a value investor).

My question was...

If you have already made up your mind to sell something, why not set a stop a little bit below that point? If the stock goes up, you profit from it. If it goes down, you still sell... albeit for a slightly greater loss.

I assume you do this because you are very sure in your reasons to sell, and you think the chance of the stock going up is too small compared to the loss you will take with the stop (excellent call on CBTE, for example).

Am I correct in my thinking?
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