Stop losses are considered a form of risk mitigation.
We think they actually increase risk.
There are better alternatives that do not come with the same risks.
Stop losses are used rampantly among both financial professionals and individuals. They are often considered a means of risk management and some firms even require their traders to use them.
We strongly disagree.
This article will detail the mechanics of triggered actions such as stop losses. We will then analyze the costs and benefits and make a case for why we believe they should not be used.
Mechanics – how triggered trading works
There are 3 kinds of triggered trades we are looking at today
- Stop on quote
- Stop limit on quote
- Trailing stop $ or %
A stop on quote order is a triggered action that automatically places a market order for the security when it reaches a certain price. A stop loss is a specific type of stop on quote in which the trader sets up a triggered sale of the security when it falls to a prespecified price.
Stop limit on quote is the same as a stop on quote except the triggered action places a limit order instead of a market order.
A trailing stop is the same as a stop on quote except that instead of it being a prespecified price, the triggering price moves with the market. For example, a trailing stop loss could be set up to float to 5% below the high water mark. As the market price of the stock moves up, the trailing stop moves up with it, but as the price moves back down the trailing stop does not move. Thus, whenever the stock drops 5% from its recent high water mark it will trigger a sale. The trader can choose the percent or specify a specific dollar amount by which to trail the high water mark.
I suspect many of you already understand how these work mechanically, but the specifics of how they work are integral to debunking their purported benefits.
Costs and benefits
Stop losses are perceived to have the eponymous benefit of stopping losses. Specifically, they are designed to limit losses to the prespecified amount.
I often hear those who use stop losses saying things like “I use stop losses so the most I can lose on a given position is 5%”.
If this were true, stop losses would be a great tool. Unfortunately, that is not how they work. Both stop on quote orders and stop limit on quote orders fail to live up to this expectation and for different reasons.
A stop on quote order does not guarantee your security is sold at the prespecified price. It merely places a market order to sell when the market hits the prespecified price. The market order can execute far below where it was intended to execute because it relies on there being a bid there.
When companies release bad news of a sufficient magnitude, the market price gaps down. If it’s a pharma company that just failed its drug trial or a REIT that lost a major tenant (or other headline risk scenario), the gap can be sizable. So the stock drops 20% and the stop loss is triggered. It doesn’t matter that the trader set the stop loss at 5% below current pricing, because there is no bid at 5% below. Thus, while it will be triggered at 5% below, the actual sale occurs 20% below. In low liquidity situations, the triggered sale can even force the price down further. When a market order sale is placed, it goes down to wherever it can find the next bid. When there are few bids it can drop quite far.
These sorts of triggered actions are the cause of flash crashes and those hurt most are the investors using the triggered actions.
A stop limit on quote is less dangerous, but equally ineffective. It will not have the same problem of driving the market price lower, but in the situations where it is needed, it will generally do nothing. If we look at the same gap down scenario discussed above, the limit will be triggered when the stock drops, but there will be no bid to match the limit order, so the investor will still own the security and have an unfilled limit sell order that is now substantially above market price.
While we like the idea of risk mitigation and most stop losses are placed with good intentions, they simply do not fulfill their intended purpose. They may make traders feel better or safer, but it is nothing more than a perception. The costs, however, are very real.
Triggered actions force one’s hand. Every second that one has a stop loss on their security it risks the following:
- Sale substantially below intended price
- Locking in adverse noise
The first we already discussed in the benefits section. It occurs rarely as it is flash crash or major adverse news scenarios that cause it, but the second can occur in any given week.
Any number of noise factors can cause a stock’s price to fluctuation 2%-7% over a reasonably short horizon. Depending on where one sets their stop losses, these fluctuations can easily trigger a sale. If we assume a stock is priced correctly and that noise causes it to fluctuate away from correct pricing, the most likely path is that it returns to proper pricing.
For those who do not use stop losses or other triggered actions, the noise is a non-event. The price temporarily dips and then returns to fundamental value for no impact on long term returns. With stop losses, however, adverse noise is locked in. When the stock fluctuates down a given amount, the stop is triggered, the stock is sold, and the investor does not get to ride the price back up to fundamental value. They have locked in the loss.
From a fundamental valuation standpoint, the logic of stop losses is backward.
The primary problem with stop losses is that they go the wrong way. When a stock gets cheaper, it becomes a better investment. Return on equity is directly related to how cheap a stock is. All else being equal, the cheaper a stock, the higher the return potential. Setting a stop loss is making the decision to not sell the stock now, but instead to sell it when it has a better expected return than it has now. That makes no sense at all. Instead, one could use ambitious limit orders.
If a stock is trading at $9, for example, one could set a “good till cancel” limit order to sell it at $10. This goes in the right direction as the stock is worse at $10 than it is at $9. Therefore, it could make sense for one to not want to sell it at $9, but want to sell it if/when it gets to $10.
Ambitious limit orders of this nature also have the benefit of locking in favorable noise. Just as a negative noise price shock will tend to correct itself, positive noise price shocks will tend to come back down to fundamental value. If one has an ambitious limit order in place and it gets hit, they will have sold the stock when it was overvalued, thereby capturing the benefit of the noise, but they will not have to ride the price back down.
We don’t use all that many ambitious limit orders because we do not like our actions to be forced. Instead, we sit at our desks all day and attempt to capture positive noise spikes manually. For those who have a different job or simply cannot watch the markets constantly, ambitious limit orders can be a great alternative.
Another alternative is to use triggered alerts. Unlike triggered actions, triggered alerts do not force one’s hand. They are simply a tool that can allow one to be alerted when pricing gets to a certain level.
We see stop losses and other triggered actions as the equivalent of hiding under a blanket. They may make one feel better, but they do not provide any measurable risk mitigation. In fact, they seem to increase risk as they have the potential to force trades at adverse prices. In price gap situations stop losses are disastrous and in normal trading volatility they lock in the negative impacts of noise.
I am confident that continuous use of stop losses and other triggered actions will reduce one’s long term total return.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.