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Larry Cyna
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Mr. Cyna is an accomplished investor in the Canadian public markets for over 20 years, and has managed significant portfolios. He is a financing specialist for private and public companies, and has expertise in real estate and debt obligations. He has assisted private companies accessing the... More
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  • Using Stop Losses – Do They Protect Your Portfolio? 2 comments
    Dec 18, 2012 2:15 PM

    Stop Losses
    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 at all.

    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.

    Stock Traders
    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.

    The views expressed in this blog are opinions only and are not investment advice. Persons investing should seek the advice of a licensed professional to guide them and should not rely on the opinions expressed herein. This blog is not a solicitation for investment and we do not accept unsolicited investment funds.

    nt funds.

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Comments (2)
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  • John TC
    , contributor
    Comments (3) | Send Message
     
    Larry, If you are so against stop losses, what is the best way to protect against a "market meltdown" as what occurred during late 2008? Also, what if you have a mutual fund in your 401K that has increased in value, and you are concerned about a big pull back, but don't want to miss a continued run up, AND your 401K does not have provisions for a stop loss? Thanks, John R.
    15 Feb 2013, 06:31 PM Reply Like
  • Larry Cyna
    , contributor
    Comments (10) | Send Message
     
    Author’s reply » A stop loss just doesn't do the job for a regular investor. Every stock bounces up and down from time to time, and your stop loss will be triggered over and over and over again before the next market meltdown. Problem with the stop loss is it turns to a market order when triggered. That means if a stock is $100 and the trigger is $80, the stock will keep selling until filled. You are not protected at $80. Your protection is only as good as whatever the price that anyone is willing to pay.

     

    As an example, yesterday on the TSX, a stock called Orbit was trading at roughly $2.60. Within a minute, it had repeated sales until it hit $1.31. 10 minutes later, it was back up to $2.31. It is a classic example of how a stop loss can really hurt you. Afterwards many of those trades were cancelled or wiped from the records, but the example is a good one. It shows how badly you can get hurt.

     

    If you use a stop loss, you must also set upper and lower limits on the stop loss. That means on the above example, you specify that you will not sell less than $75 (an example). If the stock hits $75 on your $80 stop loss, your stop loss is then cancelled. That means you won't sell at $20. That way you can only get hurt a little bit more. If your broker doesn't explain this to you, you have an issue.

     

    Anyone investing in the market must be prepared for the occasional violent fluctuation, and stay the course. If you pick almost any decent stock, you will find that it fell dramatically in 2008, but afterwards it recovered some of its value - in some cases more than it had before. If you had stop losses in, you would have been stopped out, lost your money, and not been able to afford buying the same position.

     

    There is no such thing as buy and hold any more. If you can afford to invest, you must be prepared to watch the market. You also must be prepared to watch charts. If a stocks pattern has shown a large rise, it will often correct back down. have patience. Buy in again when the stock has moderated..

     

    You have to be the master of your own destiny. When you have made a profit, be happy and move on. Having the capital to invest again is the most important part of investing.

     

    Sorry for short answer, but books could be written in answer to your questions.
    16 Feb 2013, 08:55 PM Reply Like
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