I’ve never believed that “stop orders” (predetermined prices at which to sell on the downside or buy on the upside) get the respect they deserve. Not only can they offer an important risk management tool as part of a disciplined investment approach, but they can also serve as an early warning indicator of potential trouble ahead. Unfortunately, too few market participants consider using the stop order, which comes in several varieties. Maybe that’s because this tool has a negative connotation since it’s often associated with the term “stop loss order”—where the selling price is below the investor’s purchase price. Maybe it’s because a predetermined loss level isn’t an avenue investors wish to address as soon as they purchase an issue or “sell short”—where the investor, expecting a share price decline, borrows shares to sell through his brokerage firm in the hope of buying them back (referred to as “covering”) at a lower future price and profiting from the difference. Or maybe some consider the discipline as overly stringent. Whatever the reasons, they don’t make a convincing argument. Many years ago I wrote the following words in a Letters to the Editor column in Barron’s.
Technical analysis is the only discipline I know that can help control risk by the correct use of the oft-forgotten stop order—where emphasis is placed on capital preservation, not just capital appreciation. Since the market is a discounting mechanism, the reason for a sharp decline in a stock price often doesn’t surface until after the issue has plummeted. By then, many investors feel (wrongly) that it’s “too late to sell.” Thus, technical analysis has tremendous merit as an early warning signal. Most clients have difficulty understanding (and this is especially true in bear markets) that their companies are performing well fundamentally, yet the underlying stock is doing poorly. But by understanding that poor technical stock performance may be a warning sign of an impending fundamental development the client learns to anticipate changes, not simply follow them.
There are several ways to use the stop order. One is to have a “mental stop,” where you need to be at your computer or mobile device to see your stop price hit, and then enter your order. Another is to have a pre-entered stop order on either all or a portion of one’s position. If you’re not around to continuously monitor your position, that’s an option to consider. Yes, there’s always the possibility that you’ll be relieved of part or all of the position prior to the stock’s reversing course, but in the stock market, as in life, there are no guarantees. Volatility and uncertainty are its trademarks.
In the vast number of cases when placing a stop order below the market, I would not place a “limit” order (the lowest price I would accept once the stop is triggered). Remember, the reason you place a stop order to sell a particular security is to get out of it on the southerly end and take out some or all of your money. Placing a limit raises the possibility that you will not get out of a stock even if your stop price is hit. That’s a potential problem, particularly if you own the bulk of your position as opposed to the last bit you’re trying to dispose of. The risk is simply too great.
As an example, let’s say that you’ve placed a stop order to sell a stock at $25 with a $24.98 downside limit. The shares subsequently hit $25, but the next trade is at $24.95. Since your limit at $24.98 meant that you were not willing to accept anything lower than that once your stop price was hit, you would still own the position even though your stop price was reached. That’s a real potential risk.
One idea I consider when an attractive paper gain is being realized is to place a stop on a small (10 percent to 15 percent, for example) portion of the position at the highest price that makes sense according to my chart analysis. If triggered, this serves as a reminder to immediately reevaluate the holding and consider placing additional stops on portions of the position at successively lower prices. If the shares act well thereafter and suffered only a near-term setback, I should retain the bulk of the position and can consider raising my stop(s). If not, I’ll continue to lighten the position on weakness and not reward the shares for declining in value, in keeping with our relationship investing theme. What a relief it is, after being stopped out of a position three, four, maybe even five times or more at successively lower prices, to look back and see how much money (and anguish) you’ve saved yourself by not rewarding a stock whose share price is falling. As with a relationship that’s heading south, the goal of this approach is to become increasingly less involved with a steadily deteriorating situation, moving further away the worse it gets.
On the northerly end, remember that when you’re “averaging up” a winning position, it’s psychologically easier to place a stop order since you’re experiencing a “paper gain” (meaning that the position is profitable at the moment but remains unsold). Contrast this to buying shares of a declining issue, watching it fall further in price and then having to place a stop order at a lower quote still, and you can see why that’s not a situation most market participants want to address. Not doing so leaves them potentially vulnerable to an even worse outcome, however.
In our everyday relationships and interactions there are limits and boundaries beyond which we won’t agree to go, whether price-wise or life-wise. It can be when discussing a curfew with our kids, negotiating the terms of an agreement, planning a wedding or vacation, having your in-laws stay with you (that’s a touchy subject)—you name it. These are really our “life stops,” limits that, if violated, necessitate a change in strategy. Stops can also be matched to your particular investment time frame (short, intermediate, longer term, or a combination thereof).
You won’t always be satisfied with the outcome of a particular approach, and stops are no exception. This could well be the case in instances of extreme volatility where a sharply surging or sliding market can visibly and negatively affect the price you receive. Witness what have come to be termed the flash crashes on May 6, 2010, and August 24, 2015. The former experienced an afternoon market plunge, while the latter dove at the start of trading. With these scary collapses occurring nowadays (remember these events when reading chapter 31, “One in a Million”), you’ll want to decide how much weight to assign to them when charting your investment course. Some things I’d consider in these instances are the size of my position in the security or securities, my overall equity market exposure, what I think of the market’s overall technical condition, and what can happen if I’m wrong in that assessment. Perhaps you’ll want to have your financial representative contact his strategy team to review your holdings and suggest some risk management capital preservation options. As always, it’s your call.
I utilize several southerly approaches. I may have a physically placed partial stop on the position(s), as well as a portion based on my analysis of the daily closing price charts for the shares. Referred to as “line” charts, these graphs don’t reflect the shares’ trading activity during the day, just each session’s closing price quote. This approach gives the shares an opportunity to recover by day’s end and allows me to maintain the position if my key chart areas hold, but exposes me to added losses if that outcome fails to materialize and the closing price is beneath my aforementioned, physically placed stop order.
I’ve also used stops based on my technical appraisals of shares on a weekly and monthly chart basis. If I see potentially key price areas that occur in the same vicinity after applying my analysis from a variety of technical angles, I’ll assign additional import to that zone and be more aggressive in my selling—or buying—on that basis. You need to consider some sort of discipline because operating in the stock market without an exit plan isn’t a viable option.
Finally, due to the fact that the market is more of an art than a science, and because not all stocks respond uniformly to the same technical gauges, I’m not a fan of using a set percentage loss to set your stops. It may seem convenient, but there isn’t a one-size-fits-all strategy when it comes to investing. You need to analyze each stock and market individually. Isn’t the same also true in life? The way in which we convey something to one person isn’t necessarily the tone or approach we’d use in speaking to another. After all, personalities differ and people respond in varying ways, just as not all patients will respond similarly to the same medicine.
Moral: The stop order imposes a needed discipline in your investment approach. Think about your downside strategy ahead of time because the market will test it at some point. Also consider your potential market exposure in a world where rare occurrences seem to be occurring with increasing frequency. Used correctly, stops can be an aid in stopping a financial cut from becoming a financial hemorrhage and potentially allow you to remain in winning stocks longer. Their value during a bear market climate cannot be overemphasized.
(To be continued...)
This excerpt is taken from “Relationship Investing: Stock Market Therapy for Your Money” by Jeffrey S. Weiss. To read other articles of this book, click here. To buy this book, click here.
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