Yet another attempt to figure out how to use stop orders effectively
16 July 2009. Over the years, I have tried — without much success — to use stop orders to protect gains and limit losses. The problems were legion:
- Stop orders are activated differently on the Nasdaq and NYSE: on the Nasdaq they are triggered by the bid price whereas on the NYSE they are triggered by the last price.
- Once a stop order is placed, it is considered an open order, even though it has not yet been activated.
- Outlying trades can produce unexpected and unwanted results: a single very high or very low trade, common at the start of trading sessions, can trigger a sale
Then, TD Ameritrade (where I keep my Trader Paul account) implemented something they call trade triggers: you define a set of conditions that, if met, will trigger the placing of the stop order or sending an alert. This keeps the stop-order out of the trading system (thus invisible to other traders) and prevents some spurious trades caused by exceptional events in the market.
Nevertheless, I was often disappointed in how these worked out in real life.
After mulling over several trades gone awry, I realized some shortcomings in my use of trade triggers.
• First, I had not really analyzed what I needed to protect against; the trade trigger was a "blunt instrument" when what I really needed was a scalpel.
• Second, I was using percents as absolutes, as in, for example, the old adage "If you lose 8% get out." That misses a very important point: 8% of a $5 stock and 8% of a $10 stock have quite different implications for the value of your holdings. For example, 8% of 500 shares of a $5 stock is $200, whereas 8% of 500 shares of $10 stock is $400. I have a different attitude about losing $400 than I do about losing $200.
What to do? What to do?
What to protect against
|Threats are described assuming the position is long; for a short position, the threat is reversed.|
Price suddenly plunges
Small declines add up to a big loss
Price suddenly jumps, but falls back again
Price peaks and falls back gradually
1. A sudden plunge in price is often due to unexpected bad news concerning the stock, or less commonly a stock may be pulled down in sympathy with a slump in the market or sector. Since there is no guarantee that the plunge will be reversed later on, it's best to limit the potential loss.
2. On the other hand, a sudden jump in price is often due to unexpected good news, or the stock may sometimes be swept along with general bullishness in the market, but these jumps are often short-lived, disappearing on second thoughts, so it's worthwhile locking in at least some of the gain. When opportunity knocks....
3. A series of relatively small set-backs over the course of a few days can add up to a sizeable loss. This is an insidious risk, because one is always tempted by wishful thinking: "Maybe it will come back tomorrow." This risk is highest just after taking a position: one likes to think the timing was right, but one is often wrong.
4. Stocks move in up- and down-cycles within their general trend. Especially after a solid rise in price, the risk is that the gains will be eroded while holding on in anticipation of a further rise. The mind is good at finding excuses for small, short-term setbacks: "profit-taking" or "consolidation" or "adjustment," and before long the gains have disappeared.
Amount of loss
|Price per share||8%||$ amount / 500 shares|
Thinking of limits strictly in terms of percent can have unpleasant consequences. Consider three stocks at different prices (right). The dollar amount at risk for a given percentage loss depends on the share price. Doh!
The obvious implication is that rule-making for stop orders has to consider share price. One size does not fit all.
The stop-loss strategy
|The limits in this table assume a maximum tolerable loss of $350 on a lot of 500 shares and ensure breaking even once the price is up at least .50 over the buy price.|
|Limit losses||1 - sudden plunge
If last price falls $0.70 or more from previous close, sell @market
|3 - series of small losses
If close is down $0.55 or more from the buy-price, enter a trailing stop order to sell if the price drops another $0.25 or more (GTC)
|Protect gains||2 - sudden price jump
If last price is up .50 or more from previous close, enter a trailing stop order to sell if the price falls back $0.25 or more; expire the order at the end of the session
|4 - declines after a peak
If high-close is at least $0.50 more than buy-price, enter a trailing stop order to sell if the asking price falls $0.50 (at least breakeven) (GTC)
If high-close is at least $1.00 more than buy-price, enter a trailing stop order to sell if the asking price falls $0.40 (minimum gain $0.60/share) (GTC)
If high-close is at least $1.50 more than buy-price, enter a trailing stop order to sell if the asking price falls $0.30 (minimum gain $1.20/share) (GTC)
If high-close is at least $2.00 more than buy-price, enter a trailing stop order to sell if the asking price falls $0.25 (minimum gain $1.75/share) (GTC)
So, if I'm right, then I should enter four trade-triggers when I take a position, covering each of the four quadrants in the table above.
- Protects from sudden drops at any time, regardless of the current price of the stock
- Protects gains from strong rallies
- Sets a bottom-line limit, most useful in early days of a position when the natural tendency is to bolster the decision to open the position by finding reasons to hold despite losses: "I just opened it, maybe my timing was off, I'll hold on a bit longer to wait for it to start to rise."
- This is essentially a trailing stop that ratchets upward as gains increase, with the stop tighting up as gains increase.
I keep a spreadsheet that I update every day with the closing price for each stock in my portfolio. Formulas calculate the gain(loss) at the current close and also the difference compared to the highest-closing price since I have held the stock, making it easier to manage all the stops.
|Ticker||Buy price||Latest close||Gain (loss)||High close