Stop Loss Orders: Limitations

Q. When is the use of stop losses not appropriate?


A: Using protective stops to manage risk has downsides especially in volatile markets but then there are pluses and minuses to every risk management strategy - the important thing is to have some sort of plan in place that prevents you from experiencing large portfolio draw-downs. Using protective stops on individual stock positions is one way of achieving this objective and is probably the best approach for short-term traders. However, it is certainly not the only way to manage risk and is not, in my opinion, appropriate for value-oriented long-term investors or those who speculate in securities that don't offer good liquidity.

Undeniably, 'The use of protective stops - i.e. the determining of price levels, in advance, at which you will exit if the market moves against you - is a popular way of managing risk. In fact, it may be the best way for most short-term traders to manage risk and is almost certainly the best way for traders of commodity futures to manage risk. There are situations, however, where it makes no sense to use a protective stop.

One such situation is where valuation is the primary basis for the purchase of a stock. If you buy a stock on the basis that it is being under-valued by the market then as long as the underlying fundamental story remains intact it will make no sense for you to sell in response to a price decline (a price decline will simply cause the stock to become even more under-valued). No sense, that is, unless you aren't really confident in your valuation analysis, in which case you probably shouldn't have bought the stock in the first place.

It will generally also be inappropriate to use 'stop losses' to manage risk when dealing in securities that aren't particularly liquid. Many junior resource shares, for example, routinely make large moves in response to incremental changes in stock supply/demand. In order to avoid being 'whipsawed' the buyer of such stocks would therefore have to set his/her 'stops' so far below the market that the stops would not serve their intended purpose (the intended purpose being to ensure that any loss will be a small loss).

It is worth noting that Ayondo is the only company I know that offers free guaranteed stops on most of its markets except individual shares subject to a minimum stop distance and maximum stake. Guaranteed stops can help as they protect from overnight gaps and provide additional account protection.

Q. Is it a good idea to hold on to losing short-term positions and trade for a longer timeframe?

I realise that most people set a stop loss close to where they open a position. But what if you are making short term trades over a timeframe of minutes and you open a position expecting the price to rise but instead it goes down.

If over a larger time frame(say 30 minutes) the trend looks like it's definitely down and the indicators are suggesting that, do you ever decide to allow your trade to go on for a longer term trend, rather than just cutting losses?

A: You got in short term it's gone wrong, get out, you didn't enter with a long term view so why have one now you're doing money?

If you get on the M25 intending to go 2 junctions clockwise but find you're going anticlockwise do you:

A - Keep going round all 30 junctions

B - Get off at the next junction and get back on the right track

(For those not from the UK the M25 is a huge motorway/freeway that runs around the outside of greater London)

From my own personal experience, I believe moving your stop is a very dangerous thing to do. Not only will this result in violating your trading plan but the temptation is to think, if it continues to move against you, I can't close it now, I will just wait a little bit more for it to rebound a little. If it continues to move against you, it gets harder and harder to close as you have lost so much more than originally anticipated.

Q. What are the limitations of stop losses?

A: So far as regards a stop loss or some such, I say as follows:
  1. When I enter a position I never have in mind a price below (if long) or above (if short) which I would seek to close. The reason for this is quite simple. If I were to open a position and simulataneously consider the magnitude of loss I am prepared to take, it would suggest, to me at least, and that I was not certain of my stance and hence should not undertake the trade. You only open a position if you are certain that it shall go your way, otherwise there is no point in doing it.
  2. It has been mentioned before that the 'the market can stay irrational longer than the investor can stay solvent'. Hence, inevitably occasions may arise (even for the gracious fellow) when it appears that the price action is not as anticipated. Providing one has sufficient margin, this ought not to be a concern. However, if the facts have fundamentally altered since the position was taken, then one ought to consider if a change of stance is appropriate.
    Take the example of SPD - I shorted at around 100p and then subsequently in the nineties and even lower. Initially the price went my way, with the stock going down to 85p. But I did not close since I took the view (and still do) that the company cannot make good the EBITDA forecast, notwithstanding the fact that it has stated it will. Hence the price (supported by a small free float, share buyback and ill judged comments by the Chairman) has risen considerably. Due to the factors above, it might continue its rise. But the reason I shorted has not changed. SPD is in a challenging environment, with poor sentiment, eroding margins and a complete lack of visibility going forward. Readers may suggest that it is foolish for me not to have closed at say, 100p, and gone short now. Easy with the benefit of hindsight, but the truth of the matter is I never anticipated the factors that have contributed to the rise. Such price action is immensely difficult to incorporate into any analysis, and ordinarily I tend not to focus on it.
  3. Whilst the idea of having a figure in mind as regards losses is a foolish one, often circumstances dictate otherwise. If tomorrow, all the stocks of which I am short were to double, I would be forced to accept the losses and close some trades. Thus, I never overexpose myself and have sufficient funds at the ready should a stock even incur a 50% loss or more. The other reason I do not set stop losses is because they encourage momentum trading. One can easily focus on a few per cent either side and then try to close and reopen thus scalping a few pence. This is habit forming and can lead to one missing out on having a core holding because rather than scalping a few points you do not wish to buy or short again because had you not tried to trade it you would be a few pence in the money. Such momentum trading is easy to get into, and for those who trade for the longer term is a trait that needs to be dispelled. Recently, I have been guilty of the same, but only because there has been considerable volatility. I have on several occasions traded the banks since the swings have been huge. I soon noted that I was keen to do the same with other stocks, but then reminded myself the errors that such an approach can generate, and thus stopped it immediately.
  4. Virtually most traders swear by a stop loss. The thesis is quite simple (assuming linear weighted trades) - if you maximize your loss per trade to say 5%, you can afford 10 losing trades and still simply have to call one right by more than 50% to be in profit overall. On the other hand they will tell you, without stops just one losing trade of 50% would require 10 winning trades of at least 5% to break even. Thus, the balance of probabilities would appear to be in staggering favour of such an approach.
    Not quite. If you consider that most traders simply adjust their stops as they go long i.e. if the stock moves higher for a long position, they simply raise the stop by the initial percentage towards the new price. The problem thus, is that since markets and stocks do not move in straight lines one would rarely if ever catch the full or significant part of the move since on any pullback or rise (depending on whether you are short or long the stop would have closed the trade. This is especially true in the current volatile markets. Hence the thesis of 'run your winners and cut your losers' is not really a reality for those that apply tight stops.
  5. How much I am prepared to lose on a single trade is not something to which I can give an answer since one does not exist. It really depends on what it is. If I am having a speculative punt on a AIM tiddler, I would be prepared to write off a significant loss since it would only be a fraction of my portfolio. If on the other hand, I was short a FTSE 100 company and the stock rose some 30% over a period of a year I would have to seriously consider reducing my exposure unless it was obvious it would retrace (in which case I would consider adding to the short).

It all depends on why you opened the position in the first place. That, ongoing newsflow and market forces dictate when you exit. But I always seek to exit based on facts and value, rather than price if it can be helped. So I must emphasize that watching your margin requirements and ensuring reserve capital are key.

Here we discuss the benefits and limitations of using stop losses in more detail. We also discuss where to place the stop loss level here.

 ...Continues here - Do Providers Spike Out Stops?

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