A little over a year ago, I wrote an article entitled "Stop Loss and Stop Limit Orders." In that piece, I defined the orders and explained a little about how they each work. As a review, a stop loss order (to sell) is an order to the broker to sell a specified position in the event a stock price (or even an option price) hits a certain level. For example, suppose I bought XYZ six months ago at $25 and it moved to $31.50, retraced to $30.45 and then started back up. In that case, I have a good paper profit that I would want to protect so I might consider placing a stop loss at approximately $30.10 or so (just beneath support). Now, if the stock price dipped back to my stop, the stock would automatically be sold at the market. Note that does not mean I would be assured of a sale at $30.10, it only means that the stock will be sold at whatever the market is when the stock price goes down through $30.10. If the stock gapped down at the open to $29, I might only get $28.75 or whatever the market then was, but I would be out from under the now falling piano.

Another example of placing a stop would be when the trader enters a new position. Suppose I bought ABC at $16.25 just as it bounced up off an uptrend. In recent days, the stock had traded as low as $15.90 and that price is now beneath the uptrend. In order to cut losses in the event ABC turned against me, I might want to place a stop at $15.85 so that I would automatically be taken out of my position if I was wrong on the direction.

Stop loss orders have a variety of important benefits and a few negatives. On the plus side some of the benefits of the stop loss order are as follows:

1. A decision regarding initial exit (in the event the trader is wrong on direction) can be made before the trade is ever entered and the stop placed at that level thus significantly lessening the likelihood of making an undisciplined emotional exit;

2. A stop can get the trader out of a trade that is going the wrong way even if the trader is not watching the market;

3. The placement of a stop can provide a disciplined way to cut losses;

4. The placement and subsequent movement of a stop can help prevent taking profits prematurely;

5. Trailing stops can be set so that as profit is gained, the stop automatically moves with the gain thus capturing more and more profit as a position moves favorable;

6. Stops are an indication of disciplined trading;

7. Stops cost nothing to place or change; there is only a commission when an order is filled.

On the minus side, there are at least a couple of problems, the most significant of which I think are the two that follow:

1. It can be difficult to determine the optimum price at which to place a stop and sometimes the trader can get whipsawed out of a position;

2. Stops do not afford perfect protection.

Keeping those things in mind, it is my opinion that most traders are far better off setting stops than not. Once a stop is placed, action will result if the price is hit. Unfortunately, many, if not most, retail traders who fail to use stops expose themselves to the perils of trading by emotion. The trader may decide to sell if his stock breaks below $30, for example. What happens if there is no stop and the stock does hit $30? The trader may not be watching or it may be some time before he gets an alert so the price could have dropped more by the time he attends to the sale. Even more likely, I suspect, is that the trader may see it hit $30 and say to himself: "I'll just wait a bit and see if it comes back." Murphy's Law then usually seems to go into effect and the stock drops to $29.25 and the trader then says to himself: "This is a good company, it'll come back. I'll just wait until it gets back to $30." Then it falls to $27 and $26, etc. Now when does our intrepid trader exit? If he had just set the stop in the first place and been done with it he would be out at $30 and not be suffering through the descent to $26 and below. I don't know whether you have ever done anything as foolish as that, but I am here to tell you I have. Hopefully, I will do it no more, but I am aware of my humanity and with it the ever-present chance that emotion may take over. Place the stop. It can help remove the emotion. If sold out and the stock price rebounds, the trader can always enter a new position in the same stock.

Once we decide that we will actually place stops and not just say we will place them, we are faced with an important and sometimes difficult task. Where do we place the stops? I'll address that issue in a little more detail in the article next weekend.

Good Trading!
Bill Kraft

October 20, 2007

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