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A Second Look at Stop-Loss Strategy

November 8, 2012

I want to thank all of the readers who questioned my strategy (and in one case my sanity) after reading Never Test the Depth of the Water (or the Market) with Both Feet. In that article, I reminded readers that stop losses, particularly trailing stop losses, are a handy way to limit risk and easy to set up with your online broker.

Several readers were kind enough to send their feedback. While no one questioned the basic idea behind a stop loss, several readers were concerned about entering their stop losses in the computer at the time of purchase, where the market maker can see the number.

I was glad to read their responses. One subscriber mentioned, "All of Stansberry's analysts suggest not entering your stops into the market but keeping track privately."

I've subscribed to many of Stansberry's paid services for quite a while, and I encourage everyone to check out the Stansberry & Associates website. I have several of their stock recommendations in my personal portfolio, and I have the greatest respect for the entire organization.

Subscribing to more than one investment newsletter is a great way to learn. Listen to as many quality opinions as you can, then use your own good judgment to build the portfolio that's right for you.

Balance is about more than selecting the right stocks; you also need to balance strategies and trading tactics to become a better investor.

As I read through the letters, I realized that I'd combined three separate topics: why it's helpful to set stop losses; at what level to set them; and how to use them as an investment strategy. Most readers sounded like stop-loss veterans who were comfortable with the first two, but stop-loss strategy deserves a second look.

When 55 mph Is Merely a Suggestion

Like many readers, you may worry that by entering stop losses with your broker, you're playing a dangerous game. Will the market maker drop down to your number, buy your stock, and then immediately resell it at a profit to someone else? Any investor who's been stopped out of a stock and then discovered that the low price for the day is what his stock sold for might have good cause for concern.

It's illegal for a market maker to engage in that sort of activity, but many folks think that they obey that law like many drivers "obey" the 55-mph speed limit on an expressway. Personally, I've had one – and only one – experience where I was positive that the market maker was overstepping the bounds, and that was on the buy side of a trade.

When I got my first online advanced-level trading platform, I was like a kid with a new toy. I could enter an order, see it pop up on the screen, know where I stood in line, watch the trading unfold, and see my order executed. It's neat, but it's also an eye-opener.

At one point, I entered a buy order for a stock – 1,000 shares at $X and $0.25/share, which was below the market price at the time. My order popped up on the screen immediately. I was first in line at that price.

The price kept coming down until it hit my buy price. I watched over 50,000 shares trade for a couple of minutes, but my order was never executed. Then the price jumped back up to $X and $0.50/share. I was livid!

I phoned my online broker and asked what had happened. They said they'd check the tapes and get back to me. About ten minutes later, my trade was executed at my buy price, even though the stock had risen by $0.25.

I received an apologetic phone call explaining that "their trader just missed it." Admitting to anything else would have meant admitting to breaking the law. Then I realized that the "market maker" was an employee of the brokerage firm trying to take advantage of their clients; that really infuriated me.

Once I calmed down, I concluded that if the price had dropped one penny below my buy price, the market maker would have bought the stock and sold it to me for a penny more than he'd paid. He would've skimmed $10, and I would still have the stock at the price that I was willing to pay.

I completely agree with readers who don't trust the market makers. If you ever suspect that you've been stopped out of a position by an overzealous market maker trying to take advantage of you, call your broker and complain, and demand that they check the tape.

It's important to remind the market makers that you're watching!

Alternative Ways to Get It Done

Successful investors use various strategies for stop losses. I recommend finding the one, or a combination, that works best for you.

  • End of the Day Check-In. If you set your stop with your brokerage firm and at the close of the day the stock price is getting close to your stop point, consider pulling your order before the market opens. During the first 30 minutes or so of trading, the market maker can accumulate orders and swing the market to suit their fancy much more easily. Once the market settles down, re-enter your order if you wish.
  • Self-Monitoring. Some of the more active traders use a much different strategy. They set their stop when they make the trade. Instead of entering it with the broker, they will use their phone or computer to alert them when the stock hits a certain price. Then they enter the sell order when they receive the alert.
  • Outsourcing. There are fee-based services that will monitor stops for you. These services allow you to file stops, including trailing stops, with them. They alert you when your stock hits the price, but you still have to enter the sell order on your own. One reader mentioned a company he uses that costs $40 a year.
  • Set It and Forget It. For certain stocks, I "set it and forget it." This works well for heavily traded stocks – companies like Microsoft that average 43 million shares traded daily.
  • Sometimes the Old-Fashioned Way Works Best. For more speculative stocks and those with a lower trading volume, I check my Quicken account regularly. If they go past my trigger point, I enter the order manually and watch the trading platform.

When the Extreme Becomes Reality, a Stop Loss Can Cushion the Blow

On 9/11, I was 61 years old, and my entire life savings was invested in the market. The traumatic events of that day made me reconsider how I invest.

The attacks happened early enough in the day that the markets hadn't opened yet. When they finally reopened on 9/17, the DJIA dropped 684 (7.1%) that day. By the end of the week it had dropped 14.3%. The S&P dropped over 11.6% for the week, on top of the 26.9% that it had dropped in the past year at the end of the Internet boom. Airline stocks and stocks in affiliated industries tanked.

Investors were on pins and needles, worrying about the opening prices of their investments when the markets reopened. We had one particularly reckless friend who believed in making full use of his margin account; he was terrified. His broker could have easily been selling off both his winners and losers to make a margin call.

With most online trading platforms, you can cancel an order during non-trading hours. Certainly if there were an event like 9/11, with a long gap between the market closing and reopening, I would probably cancel all my stop-loss orders.

Otherwise, if a stock drops below your stop-loss price, your sell order would be entered immediately and you'd be stopped out at the market price. I would be sitting behind my computer the minute the market opened, hoping it cooled down before deciding what to do.

If however, another catastrophic event like 9/11 were to occur while the markets were open, a stop loss with your broker certainly increases your chances of getting out of your position as the stock moves down. Based on personal experience, I think there's some risk in not having a stop loss entered in your broker's computer system.

You've probably read about the high-speed computer trading platforms that allow firms mere millisecond advantages in getting their trades placed. Should the market go into a panic mode, these automated traders could easily put in short sell orders and the price of a stock could drop like a rock. Theoretically there are procedures put in place to prevent that from happening, but honestly I don't want to trust my money to the idea that they might work.

Ask any old-timer if they've experienced a situation where panic prevailed: they tried to contact their broker, there was a modest delay, and they watched their profits erode until their trade finally got placed and executed. It's not fun.

One of the primary reasons for setting a trailing stop loss is to protect some profit in the event of a quick reversal in your stock price.

I certainly understand the argument for not entering stops with your broker. If you have the time and ability to stay on top of the market and get your orders entered in a timely fashion, you may want to consider other ways of dealing with your stop losses.

It's important to understand and weigh all of the risks. There is a risk that an aggressive market maker will take you out of a position because he's seen your stop-loss order. There is also a risk of your stock rapidly sinking below your stop-loss target because of a timing delay in getting an order placed. Pick the strategy you're most comfortable with and act accordingly.

Keep the Letters and Cards Coming

Your letters reinforced my message in Getting the Most from Your Investment Newsletters. Read a variety of opinions, factor in your personal experience, and decide what works for you.

Please keep the cards and letters coming; I want to hear from you!

On the Electoral Side

I'm still getting used to meeting a weekly deadline. I try to get as much on paper well in advance to allow for last-minute changes.

When it came to my feelings about the election, there were some points I wanted to share regardless of who won, so they were easy to write ahead of time.

As a senior who has voted in many elections, I can confidently tell you two things. First, all officials up for election in 2014 began their campaigns yesterday. And second, the phrase "political promises kept" is an oxymoron – unless you're a big campaign donor.

When the new Congress is sworn in, the majority party will attempt to pass legislation to reward its supporters. The minority party will focus on obstructing that agenda.

"Bipartisanship" is merely working together to pass legislation that will help both parties' chances at reelection. It has nothing to do with doing what's right for the 100 million or so folks who voted.

I don't want to sound cynical; it just seems that's the way things work. A little more than half of the voting public will be quite happy (for a moment); their candidate won. A little less than half will be upset; their candidate lost.

Our nation has become polarized by the political class. One side says the other is lazy or "on the government dole." Others complain that those on the opposite side of the aisle are rich and greedy, or "not paying their fair share." It's pathetic.

As of Monday, the polls were close. I've read that both sides are gearing up their lawyers for potential challenges long before the results are in. I hope what we experienced in 2000 never becomes the norm. Our country does not need to go through that upheaval again.

I prefer it when elections are decided by the voters. It's sad when political parties have "their" justices twist the Constitution to fit their political persuasion.

Fortunately, neither the high expectations of folks who voted for the winner nor the worst fears of those who voted for the loser usually ever come to pass. Two years from now, we'll go through the same drill with Congress again, and in four years we'll watch the same dance for the White House.

My message? I plead for perspective. I hope folks on both sides can calm their emotions quickly. I much prefer enjoying Thanksgiving and Christmas without a gray cloud of election results affecting the mood of our country.

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As I write, the major networks are announcing that President Obama will continue to lead our nation for the next four years. He has some big challenges ahead, such as addressing the expiration of the Bush tax cuts.

Regardless of the election results, however, Money Forever’s goal remains the same: to help you survive and thrive in tough economic times.

The next presidential-election dance will begin in a little over three years, when a new set of candidates will promise to lead our nation to a balanced budget and full employment. Same old promises, just different faces. Hopefully our country will emotionally settle down now and get back to work.

And finally…

On Friday my SSR group heads for the Florida Keys. By Saturday there will be 100 of us down there taking up an entire parking lot. It's quite a sight!

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Last week I shared some Will Rogers quotes. Here are a few more on aging:

"Some people try to turn back their odometers. Not me; I want people to know why I look this way. I've traveled a long way, and some of the roads weren't paved."

"The older we get, the fewer things seem worth waiting in line for."

"One must wait until evening to see how splendid the day has been."

Until next week…

 
 

About the Author

Over the course of his career, Dennis Miller has consulted with many Fortune 500 companies, training hundreds of executives to effectively communicate the value of their company's products to their customers. Among his many multi-national clients are: GE, Mobil, Shell, Schlumberger, HP, IBM, Corning Glass, Eastman Kodak, AC Nielsen, and Johns-Manville.

An active international lecturer for 40 years, Dennis wrote several books on sales and sales management. He was a contributor to... read more