Stop Loss Discipline
Research for Online Investors

This article originally appeared in MarketToday on 12/29/10

by John Dalt

Stop losses are a tough discipline to follow, believe me. I still violate trailing stops occasionally. In hindsight, it is always is easy to see a trailing stop left money on the table. When I see this it makes me want to be brave and ‘hang in there’ against the market. But, 9 times out of 10, I would have been better off to stay with the discipline.

We have an excellent article on Trailing Stops you may want to review in our Investor Resources section at the website.  If you haven’t read it in some time, or want a basic primer in trailing stops, it will help you.

This article is written for the long-term investor. The primary point is to NOT enter the trailing stop in your computer. Floor traders will dip the market to take you out. As an example of the dangers of entering trailing stops in your computer, look back to May 6, 2010. That was the day of the “Flash Crash.” Liquidity disappeared from the market, and stocks dropped quickly as trailing stops were triggered, but there were no buy orders to take them.

High frequency trader’s computers pulled away from the market and watched it fall.  Proctor and Gamble (PG) opened that day at $61.19 and closed at $60.75, not to bad of a loss on the most turbulent day the market saw last year.  Except during the day it hit a low of $39.37!

This was the lowest price the stock had seen in over seven years.  How many retirees saw their long-term position in PG sold that day?  I don’t know, but they had to be sick about it.  Again, never enter stop losses in your computer against long term holdings.

We monitor trailing stops for our long-term portfolio subscribers.  If a stock closes below our trailing stop, we issue an order to sell it the next day.  Our trailing stops are triggered on a “closing price” only.

We covered a story about a “professional” money manager that lost almost all of his customer’s money in the Flash Crash…because he entered stop losses in his computer.  Flash Crash Victims has the story.

If you trade, as we do in SwingTrader, it is ok and in fact recommended to enter your stop losses in your computer.  The reason for this is you are looking for a quick gain, against a risk of a well defined small loss.

In SwingTrader we do not use “stop” orders, we only use “stop limit” orders. Why? A “stop” order becomes a market order if the stock price drops to the “stop” price. During the “Flash Crash” stop orders were triggered and became market orders, but there were no market buy orders so the price kept dropping, and dropping. Eventually some brave soul realized how cheap the stock was and entered an order. Surprise...he bought PG at a seven year low! Others started buying, and within a few minutes PG was back up to its fair value price.

A “stop limit” order has a very important distinction. When the stop price is hit the order is converted to a “limit” sell order. We want to sell the stock, but only at our limit price. PG could continue to fall, but we would only sell at our limit price. As it recovered (hopefully) and crossed back past our limit price, the order would be executed.

There is one time we do not enter “sell limit” orders in the SwingTrader.  We are in such a time right now.  The market’s low volume is dangerous for traders.  Volatility increases because of the lack of active traders.  We could experience wild price swings because of the lack of buyers.

At times such as this, we watch our stops on a “closing basis only.” We treat our stops in trading the same as we always do for long-term investments. If the stock closes below our stop limit, we will sell it the next day. We would not have any stop limit entered in the computer, as we could get ‘whip-sawed’ out of good positions because of the increased volatility that comes from low volume.

Good trading, and be careful. If you would like to trade the market with discipline, check out the SwingTrader. We like to hold stocks or options for a few days to a few weeks. We look for one good set-up per day. Take our profits and go on to the next one.

To the mailbag:
I’m sure glad I bought my Ford Fusion Hybrid that gets 41 mpg.  The neighbors laughed at me when gas was 2.75. We never learn in this country until we are flat on our backs.  Maybe a dictatorship is the better way to go.--- paid up subscriber J.P.

John’s reply:  A dictatorship means you would have bought a Yugo.  And all of the environmentalists that stop us from exploring for our own abundant oil, coal and nat. gas would be in a gulag.  On second thought….there is one positive!

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions.  It may contain errors and you should not make investment decisions based solely on what you believe you have read here.  Do your own research, it is your money.  If you lose it, it is your responsibility, not ours or your grandmothers!  The editor may or may not have a position in any securities discussed.  The editor may have held a position in a security earlier, or in the future.

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