In today’s Money Morning…how stops can be used…the story is more important than the price…stop-losses can make you complacent and lazy…and more…
‘If I catch you using a stop-loss, you are fired!’
This is one of the first things I was told when I went into professional trading. I may have embellished the ‘fired’ part. To be honest, I don’t remember the exact wording.
But in my first week of trading, I was told in no uncertain terms that I was not to use stop-loss orders (stops) ever!
This was a bit of a shock.
Before that I had devoured every book on trading and investing that I could get my hands on. Many of them recommend stops as an essential part of any trading plan.
Now, you may be reading this and thinking, ‘That’s great, Izaac, but I am not a professional trader!’.
Now, hear me out.
I am going to tell you exactly how I think stops CAN be used. They DO have a place, but you might be surprised to learn exactly how narrowly I think they should be used.
But first, I want to tell you about two very important reasons why you should be wary of using stops.
The story is more important than the price
So why am I talking about this?
I had a recent question from an Exponential Stock Investor subscriber about a stock that had fallen 50% since we recommended it.
They wanted to know if we were concerned, and shouldn’t we be recommending selling it.
The thing is, nothing had changed in the story; all products have moments of irrational pricing — even the most widely traded and liquid markets.
Early on in my career, I got caught in some end-of-month flow in the SPI (S&P 200 future). You can think of the SPI as a highly leveraged way of trading the Australian share market, with the added bonus that it trades overnight.
The share market had just closed.
Some large institution had been caught out needing to rebalance their positions before the end of the futures session, which was less than 20 minutes away.
The SPI future spiked down 2% in about two minutes. I got caught on the wrong side of the move.
I was well past my daily stop — the maximum amount a day trader is allowed to lose in one day.
But the worst part about it was I didn’t buy more at the low of the spike down. This was one of those days where the right thing to do was to break the rules.
One of my mentors loaded up heavily at the lows — and make no mistake, on the way down as well — and made a killing.
I got out on a bounce for a more reasonable loss. I was too focused on the size of the loss I was seeing to take the right action and buy more.
It’s easy to say in hindsight, but that move was completely against all idea of value — it was pure opportunity.
Often when people are taking their stop-losses is when they should be buying more.
But certainly not always!
How to Limit Your Risks While Trading Volatile Stocks. Learn more.
If you are down 50% in a stock, there are two questions you should be asking yourself.
First, should I exit the trade for a 50% loss? To answer this, you just need to know if the original trade idea is still intact. That is a whole lesson in itself.
It’s particularly hard with high-growth speculative stocks to have any idea of value. The price can swing around without a change in the story.
If you are in a trade, you need to know why. If you know why you are in a trade, then you will know when it’s time to exit without thinking about it. Is the original idea still valid?
If the answer to the first question is ‘no’, and you should still be in the trade, then the next question is: Should I add to the position? If it’s still a good idea, and still intact, are you looking at an even better opportunity?
Now, obviously, you need to be careful about how much money you put into any one opportunity. You need to stay diversified and responsible. At Exponential Stock Investor, we sometimes advise our subscribers to invest half of what they want to on a stock, just in case it falls and provides a better entry.
Into action
There is a second very important reason not to use stops. And this might surprise you.
Stop-losses can make you complacent and lazy.
Say you enter a trade and put a stop-loss order in to manage your risk. What if something changes in the story?
Maybe a company will release some bad news, maybe a key support breaks, or maybe the price action will just be ugly…or a large systematic seller shows up. Any of these can happen.
Instead of getting out quickly, people will just watch the market trade down and trigger their stop. But they could’ve gotten out for a smaller loss.
It happens all the time.
Well, that is just silly. You know where it’s going, so why are you just watching it? That is the time to act, when you know you are on your way to eating your stop.
So when should you use a stop-loss? Why do they exist? There are two very good uses.
Firstly, to execute a very specific idea. If your idea fails when the price breaks a support level, then a stop may be a good idea.
Secondly, and this is the most important use, for risk management…to limit ‘unacceptable’ losses. This is different to a conscious decision to exit a trade because the trade is no longer good.
The main thing is, though, just because something falls, doesn’t mean you should eat that loss. Sometimes that is when you can make your month or your year!
There is nothing wrong with placing a stop-loss on a position to manage your risk. The key point I want to leave you with today is that you shouldn’t let that stop-loss order make the decision for you. Always be asking yourself whether the trade is still good or not.
Until next week,
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Izaac Ronay,
Editor, Money Morning
PS: Izaac is also the editor at Exponential Stock Investor, a stock tipping newsletter that hunts for promising small-cap stocks. For information on how to subscribe and see what Izaac’s telling subscribers right now, please click here.
