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Using Stop Losses - Do They Protect Your Portfolio?
In its simplest form, a stop loss is a standing instruction to your broker that if a stock falls in value to a certain point, an order will be automatically executed to immediately sell that stock at the market price.
The Purpose Of Stop Losses
As part of the traditional psychology of investing in the stock market, a caution is often given to clients that the use of Stop Losses is a normal and conventional way to protect yourself against losses in your stock when a stock falls in value. Supposedly, the theory goes, some stocks will go up, and some stocks will go down. Theoretically stop losses protect you against those stocks that will go down, by setting a maximum loss that you can incur on those stocks. The sadness of the matter, is that the theoretical manner of dealing this way, differs very much from the day to day actual results. Here's why.
To use this strategy, you first have to set a amount that is the maximum loss that you are willing accept on a particular stock. To use an example, if your risk tolerance is 20%, and you buy a stock for $100, you can accept a loss of up to $20, but are not willing to accept any greater losses. In an ideal world, that means that as soon as the stock hits $80, it is automatically immediately sold.
Would that the world worked that easily, but it doesn't. Let me explain.
In Fact, Stop Losses Are a Fool's Game
In order for the strategy to work, there must be several conditions precedent. Firstly, there must be enough buyers willing to pay the asking price for that particular stock. To meet this condition, the volume in that stock must be sufficient to ensure that there are normally lots of buyers for the stock at prices that are close to the current offering price. The problem is that many stocks do not have this type of liquidity as the spread in price between bidding and asking price, can be significant. In basic terms, that means that in a normal market, what current buyers are willing to pay can be several points below what sellers are willing to accept. Therefore, if you bought the stock at a higher point, you would have already lost sme of the value by selling a semi-liquid stock when it really hasn't yet moved.
So let's assume that you are convinced that a stock is worth buying and you pay the price asked by the seller, and then to protect yourself you place a stop loss on the stock. Now there are market rules that prevent the difference between asking price and bidding price from being too large, but if you have a larger position, the amount of stock being bid for, may not be sufficient to liquidate your position if the stop loss is triggered.
So the first problem is liquidity, which determines if the stop loss will work
But let's assume that this pitfall is not in your way. Let's assume that supply and demand are in rough balance and there are lots of buyers and let us examine that situation.
The Belief That A Stock Price is Based on Some Mutually Agreed Valuation
The very essence of the stock market, is that the perceived value of a stock varies dramatically because of many factors. So a stock priced at a value today will move up or down tomorrow because of 1) the company does well, or not, 2) the general market goes up or down, 3)some other factor unrelated to the stock causes people to like or dislike it, 4)some professional trader decides to use that stock to make money, or 5)a thousand other reasons.
Market sentiment causes stocks to rise and fall in value dramatically and usually without warning. Let's assume that the $100 stock drops precipitously for some reason, and then rebounds because the market decides that the fall was too dramatic. This happens for many reasons, including a fund deciding to liquidate a position and giving instructions to sell at market, which means that every offer at any price will be accepted until the position is sold. When this occurs, there is a dramatic and temporary loss of value. In this event, your stop loss, should be renamed "Guaranteed to Lose". You will be stopped out of the stock, at $80, only to watch it rebound the same day to $90 or $110 while you watch in frustration.
This is by far the most common result of using stop losses. A guaranteed loss for the reason that the stock momentarily dropped in value.. One way to make money in the market, is to maintain stink bids. A stink bid is a bid for a stock at a price far below current market. You might be surprised at how frequently a stink bid gets filled. Stocks tend on a very regular basis, to have dramatic swings in value, even on an hourly basis. The person with the stink bid on your stock, just bought your stock when your stop loss got triggerred. Therefore your protective stop loss did not protect you. In fact your stop loss financially penalized you and ensured that your loss would be permanent.
We move now to another common scenario resulting from stop losses. When one invests in the stock market, one assumes that the rules are the same for everyone. That is a pleasant but naive thought. Depending on who you are, and how connected you are, and whether you are a professional trader or not, the information available to you can be very much better (or for the average investor - information is generally unavailable). Professional traders are able to see on their screen every bid or ask on a stock and understand when a stop loss is in place. Stories about professionals driving a stock down in order to cause a stop loss to be executed so that they can buy the stock at a bargain price. Perhaps these rumors are unfounded. Perhaps not.
In our next piece, we discuss How Stop Loss Orders are a Guaranteed Loss of Unrestricted Magnitude.