Should You Have A Stop Loss Order In Place?

Includes: BAC, DDAIF, TM, TSLA
by: Andrew Cherna

I received this comment from John Petersen in response to a comment I made challenging his viewpoint on one of his bearish articles about Tesla (NASDAQ:TSLA):

"I've been practicing securities law for longer than you've been alive. In time you'll learn that not covering your downside is the most painful portfolio mistake you can ever make. If you can tell me that you own Tesla with a tight trailing stop loss, I'll call you a speculator. If you own it naked and long with no downside protection I'll call you inexperienced."

-John Petersen, (Tesla Bear and Practicer of Securities Law for Longer than I have been alive)

Here was my response to John:

"I am fortunate enough to be able to take a small position in TSLA that I can afford to lose completely. I like that I'm supporting a visionary who just was the first man to take a private rocket into space. If I lose it all, fine, but if I missed out on an opportunity to get in on the first successful electric car company in history, I will be kicking myself for the rest of my life. This stock is so volatile, a stop-loss order doesn't really make any sense to me. Especially given the incredibly high short interest."

Discounting the fact that I think it is very unlikely that Tesla will go bottom up with the upcoming Model S and Model X releases, its partnerships with Daimler (OTCPK:DDAIF) and Toyota (NYSE:TM), and a variety of other positive factors working in its favor; even if I did think there was a pretty good chance that Tesla could go bottom up, I would never put a stop loss order on the stock. He also chose a terrible example with Tesla, a very volatile stock that I watch go up and down 4-6% daily.

The whole idea of having a stop loss order makes absolutely zero sense to me. Back in the 1960s or 70s when John was practicing securities law and I was busy not existing, trading was much slower. The internet did not allow you to make immediate transactions with the click of a mouse.

Nowadays, I monitor about 50 stocks in my watch list and personally hold 12 equities. I am also loosely following many other stocks with which I am aware of price action. With Seeking Alpha's live updates, the Internet, TV, and everything else, I can see exactly where my investments stand, up to the second. I can execute transactions in seconds. With this technology, I see absolutely zero reason to call up my broker and put in a stop loss order to mitigate any potential losses when I know and can summon the exact share price of my equity, and if needed place a quick call or email to my broker and sell.

Another reason why I do not really understand the concept of a stop loss order is that I am a long-term investor. Each of my 12 holdings I have done a fair amount of research on. I like all of them as long-term investments. The market is not sure what to do with itself right now. Friday everyone is selling, today everyone is buying, there is really no direction anyone can point to. I am tuning all of this out. I like all of my companies, and if they go down, that is OK, I will consider adding to my position. I am not looking to panic sell in order to mitigate my losses.

Here is the first result I received from Googling "hedge fund stop loss order trigger"

From Zero Hedge 11/15/2011:

"Earlier we warned everyone that the Goldman stop loss triggers were if not hot then would be any minute. That just happened and the EUR USD tumbled a good 40 pips in seconds as soon as the several supporting bids just below 1.35 were finally eradicated, bringing the Euro to a 5 week low. And as a reminder, tomorrow we have some very interesting Spanish and French bond auctions. As another reminder, both closed at record spreads. Better set that alarm for 2:45 am: things are getting dramaminy once again."

And here is the accompanying picture to go along with it:

(Click to enlarge)

This brings me to my last point about stop loss orders. People tend to mindlessly think in round numbers, like 1.35 or even share prices like 20 and 25. I'll admit, the math is easier to calculate your losses on these nice, even share prices. The problem is, hedge funds and Wall Street all know this because they have really smart people working for them. Hence, things like this happen with Bank of America (NYSE:BAC) when it hit the $7.00 level 09/09/2011 (second result from Google search for hedge fund stop loss trigger, by the way, also via apologies if the picture is hard to see here, you can click the link for the original source.) Anyway, you can see the severe downward price action in red.

(Click to enlarge)

Thus, if you must insist on having a stop loss order in place, have one with a very random number. Like $12.34 or $7.36. That way, you will not be involved in an avalanche of stop loss orders like in the Bank of America example. Even still, it would still be possible to get caught up in the downward pressure of a stop loss order at a round number, so I advise against all stop loss orders. This is only if you must have one, I would say a random share price is the best course of action.

It is a known tactic of smart Wall Street people to trigger stop loss orders via downward pressure on the share price. This means that they know there will be further downward pressure, at which point they can use any number of tactics to profit and also accumulate more shares at an artificially depressed price because of the stop loss order, and also take advantage of profits via short selling.

In closing, I do not at all believe in stop loss orders. However, for those who have very large stakes in the game, it could possibly make sense to have one in place at a random share price in order to mitigate losses.

What do you think? I am a crackpot young person who needs to learn how to mitigate losses? Or am I actually onto something? I am very interested in your thoughts.

Disclosure: I am long TSLA, BAC.