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Wednesday, March 18, 2009

Stop Losses

Excerpt from David Korn's Stock Market Commentary, Interpretation of Moneytalk (Bob Brinker Host), Financial Education, Helpful Links, Guest Editorials, and Special Alert E-Mail Service. Copyright David Korn, L.L.C. 2009


First, a word about terminology. The term, “stop loss” is also referred to as a “stop order.” Essentially, it is an order to your broker to buy or sell a security once the price of the security has climbed above or dropped below a specified stop price. When the specified stop price is reached, the stop order is converted to a market order and you get the next price of the security.

For purposes of this primer, I am primarily focused on the aspect of implementing a stop loss to be executed once a security you own goes DOWN. This is designed to protect you from further losses.

The stop loss concept is very simple, deceivingly so. Say you purchased a stock at $100, but didn’t want to risk anymore than 10% of the money you invested. You put a stop loss at $90, and if during intra-day trading the stock traded at $90, your stop loss order would be triggered and you would be sold out of the stock at $90 (assuming a liquid stock) and you would be out of your position. If the stock then went to $1 a share, you would be congratulating yourself on how smart you were to limit your losses to $10 a share. If the stock touched $90, triggered your stop loss, but then shot up to $500 a share, you might be kicking yourself for years to come. The latter would produce strong feelings of seller’s remorse. But it wouldn’t destroy your portfolio. It would simply mean you would have lost out on an opportunity.

What is the difference between a "stop loss" and "stop limit" order? A "stop loss" order WILL sell your shares immediately once your stop-loss price is executed. In my current QQQQ trade, once shares hit $24.97, the next trade below that will automatically sell my shares. A "stop limit" order will ONLY sell my shares if QQQQ trades at $24.97 and there is a buyer at the other end. The difference between the two could come into play if, for example, the market opened way way lower (i.e. after a terrorist attack). Suppose the QQQQs gapped from $26 and opened up at $20 when they resumed opened for trading. Under that scenario, the stop-limit would not have been executed, and I would still own the shares, whereas the stop-loss would give me the first trading price below the stop-loss price (presumably $20 in this hypothetical).

The stop loss can be one of the most important tools in anyone’s investment portfolio. But its importance is not so obvious. And the reason for that is a premise that I ask you to consider by answering the following questions:

How easy is it for you to buy stock you don’t own or purchase more shares of stock you do own? (assuming you have the funds)

Now ask yourself this question. How easy is it for you to sell a stock that you own?

Here is the really tough one. How easy is it for you to sell a stock that has already declined from the price you paid for it?

If you are like me, and most humans, the truth is that it is very hard to sell a stock at a loss. As a position starts declining, our brain’s wiring goes into an irrational mode. Behavioral finance has studied this phenomenon and offers several explanations to describe the psychological reaction that occurs. One theory is that individuals follow the Kubler-Ross model of the Five Stages of Grief when a stock that they were certain had the potential to go up, declines markedly. First, you go into denial that the bad news impacting the stock is true. Then you are angry and blame third parties (such as short-sellers for example). Then the bargaining process begins (well if I wait a little longer, things will turn around or I could double up on my shares). Then depression — being paralyzed by the movement, and finally acceptance. The problem is the acceptance part of it all comes way too late in the game. By then, the stock has already gone through its declines.

The breakeven fallacy is adopted by many investors who are in a losing position. The brain rationalizes the losses under the fallacy that the security will reach a break-even point at which they put their money in and at that point they will sell. This might work for a diversified holding like the total stock market provided you have an extremely long investment horizon, but it doesn’t work so well for individual issues. (As a side note, some traders assign support and resistance levels to stocks that they believe represent a break-even point for many investors. But that is a topic for another day).

The stop-loss order, in my opinion, should be decided in advance of your purchase. Why? Because if you do it then, you are not emotionally vested in the position. Your ego won’t be bruised because you made a mistake and purchased a stock that immediately went down. By setting the stop loss in advance, you are simply evaluating how much you are willing to risk losing before you even put a penny of your money into a stock. If you wait until you establish a position, and then there is a sudden move in the stock in either direction, the stop-loss level you choose will be colored by the emotion of what just happened to the stock and you might act irrationally.

Trailing Stop Losses

When stocks are rising, I like the practice of using trailing or laddered stops. A trailing or laddered stop is simply a stop order that is raised periodically to compensate for changes in the price of the security. Trailing stops can be used to protect against losses, and to lock in profits and let them run. A trailing stop that is incrementally changed to follow the current trading price allows profits to continue, but presumably is far enough away from the current price level to compensate for intra-day volatility as price moves into a larger trend. That is exactly what I am doing now relative to the QQQQ shares. A word of caution: make sure you cancel your previous stop order every time you raise it.

Some online brokers offer trailing percentage stop orders. These types of stop orders work with a ratchet effect, trailing price movements by a set percentage but only in the direction of the trend. If the price reverse direction, the stop remains at the previous level and will be activated if price reverses by more than the trailing percentage. Here is a link to an article showing visually how this works:

Another Example

Some people think stop-loss orders are only for the penny stocks. Not true by any stretch. Let’s use one of the bellwethers by way of example. Suppose you purchased General Electric back in the 1999-2000 time frame. General Electric was considered the bluest of the blue-chip companies at the time and was one of the most widely held stocks, not only by institutions but also by individuals as well. Jack Welch was at the helm and over his 24-year term, the company went from a market cap of $14 billion to $410 billion. From 1990-2000, the stock had risen from $10 to $60, and shares had split three times with hardly a correction along the way. A series of trailing stop losses with enough room for relatively contained pullbacks would have allowed you to capture the bulk of the gains before the stop loss ever was triggered.

When the bear market of 2000-2002 came about, if you had been exercising trailing stop losses, you might have been able to lock in a large part of your gains. (It depends of course on how deep your trailing stops were).

Now flash forward. For about 5 years (2003-2008), General Electric was trading in the neighborhood of the $30-$40 range. There was probably a lot of cumulating of the stock during this time frame. In the last 52-weeks, GE traded as high as $38.52. The $30 was certainly a support level that stood for a long time, even as of September of last year. The stock then slowly, but orderly, declined from about $30 to about $12 last November when the market reached its lowest point of 2008. The stock then rallied a bit going into the new year, but once again started its decline to eventually hit its 52-week intra-day low of $5.87 on March 4th, and closing low of $6.69 the same day. It has since rallied to $9.62 where it closed Friday.

There were many times over the course of the last decade that a stop loss would have prevented much more serious losses in GE. The same holds true for many stocks (particularly in the financials and housing stocks) over this bear market.

Incidentally, I used GE as an example here in part because the company was in the news this week when Standard & Poor’s credit rating agency downgraded the company from AAA to AA-Plus, the first time ever. Barron’s has a feature article out this weekend saying that bonds of GE’s financial arm, GE Capital, are looking attractive despite still holding some risky assets. GE Capital’s bonds are yielding a full percentage more than those of the parent company. That kind of individual corporate bond ain’t my cup of tea, but if it interests you, here is a link the Barron’s article entitled, “GE: Bringing Good Bonds to Life”:

A final word about stop loss orders and trailing stops and the like. There is no panacea to investing. Charter subscribers of mine have seen me get stopped out of a position that subsequently rallied. Other times, I couldn’t have been happier that a stop loss was triggered. JP Morgan Chase is a good example of that last year. I think on balance, the use of stop losses has been net very positive for me and I encourage all of my subscribers to learn as much as they can about them. To that end, let me know if you have any follow up questions on this topic.

To learn how to subscribe to my newsletter, simply click on the link at the top of this web page. - David Korn

DISCLAIMER: The information contained in this newsletter and or published on my web site, is not intended to constitute financial advice and is not a recommendation or solicitation to buy, sell or hold any security. This newsletter is strictly informational and educational and is not to be construed as any kind of financial advice, investment advice or legal advice. Copyright David Korn, L.L.C. 2009.

David Korn writes "The Retirement Advisor" and "David Korn's Stock Market Commentary, Interpretation of Moneytalk (Bob Brinker Host), Financial Education, Helpful Links, Guest Editorials, and Special Alert E-Mail Service" newsletters.

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