Do you invest using stop loss orders?

6116 Views 9 Replies 4 Participants Last post by humble_pie, Sep 16, 2014

dime

Discussion Starter · Sep 13, 2014

I've never used stop loss orders before, and am thinking I should have been using them decades ago.

I ran some back tests (TD's recognia) that shows a significant difference between just buying and holding the top picks of the season, VS setting a 7% trailing stop loss. The stop loss exit showed double the performance of the buy and hold approach, with much less portfolio volatility. But it does seems like an extra bunch of time and work to set stop every week for two dozen different stocks. My TD account unfortunately does not seem to let me set a % trailing stop, so I'd need to update the stop loss manually every day (or every week?).

What does everyone here think of investing using stops?

Some thoughts:

- Stops are a way to mitigate some of the inherent risks of losing capital in the stock market. At the same time the trailing stop is a way to practice discipline so you exit a losing positions while ride winning trends. It helps prevent some of the stress that comes from knowing when to sell a stock.

- My tests seems to show a 7% trailing stop to work best.

- Don't set a tight stop to early. Allow for some 'wiggle room' as it's hard to pick a perfect low point for buying. You don't want to get stopped out of every trade and may take some time after buying before the stock moves up from where you bought.

- Not to set the trailing stop too tight during the trending action upwards in price. The normal periodic volatility could stop you out of the larger upward trend.

- The risk increases and potential reward decreases as you reach your trading target, so you might want to tighten the stop as you approach your target.

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james4beach

· #2 · Sep 13, 2014

You first have to learn a lot more detail on how those simulations deal wth stop losses down to the nitty gritty.

For instance is the back-test only using close of day values? Or would it trigger the sell-on-stop with an intraday, even extremely brief, decline in price below the stop? In real life that's exactly the kind of volatility that would trigger a stop, killing your position even if it closes much higher the same day.

Additionally, does their back testing platform have second-by-second granularity of the bid and asks price along with the order book at each state? I seriously doubt it -- that's an immense amount of data. This becomes important because once a stop triggers, your stock doesn't get sold exactly at the stop price. Instead, you will get a fill at "market" which could be quite a bit below your stop price.

These are nuances that create a divergence between such back test simulations, and real life. I suspect that you're getting a rose coloured view of what stops can accomplish for you. Large swings tend to occur pretty frequently in individual stocks, and 7% would be considered an awfully tight stop. I suspect that if you used this method in the real market, your stops would trigger a lot more often than you expect, hurting your returns.

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james4beach

· #3 · Sep 13, 2014

By the way: although I don't use stop orders, I * do * use mental stops. Which means that I decide my stop price and manually monitor for the threshold. I'll act on it pretty loosely, like weekly or monthly granularity.

You may want to investigate such a strategy because this solves the volatility/sensitivity issue with actual sell-on-stop orders.

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dime

Discussion Starter · #4 · Sep 14, 2014

Some really useful feedback to consider there James. Thanks. My gut feeling is the simulation is only using EOD data. And certainly some stocks have a higher volatility than others. 7% is a wide margin for some stocks with low beta, but not for others. I

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james4beach

· #5 · Sep 14, 2014

Here's a situation you should look into: gaps down.

A stock may gap down at the open, falling a large amount, and trigger the stop. Typically in these cases a flood of stops get triggered at the open (people tend to put their stops at the same price), further pressuring the stock downwards. When your stop order fills, it will be at a worse price than the threshold you defined.

That's one clear example you might want to look into

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humble_pie

· #6 · Sep 15, 2014

persons considering a stop loss order are obviously already ambivalent about their selling intentions. So why not get paid to dither?

sell a call option every month until the drat thing gets taken out, pocket the cash & forget the penniless stop loss.

hint: some brokerages have already lowered option assignments to a flat fee. But other brokers are still charging an insanely high agent-handled commission for an option assignment, so it would be a good idea to negotiate one's broker down to a flat fee in advance of such trades.

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Woz

· #7 · Sep 15, 2014

@humble_pie

Can you explain a bit more about how you could sell calls to replicate a stop loss?

If you’re selling a call option then it’d be exercised if the market price is above the strike price. That seems to be the opposite of what you want to happen with a stop loss. I could see buying a put option to replace a stop loss, but then you’re paying a premium.

humble_pie said:
persons considering a stop loss order are obviously already ambivalent about their selling intentions. So why not get paid to dither?

sell a call option every month until the drat thing gets taken out, pocket the cash & forget the penniless stop loss.

hint: some brokerages have already lowered option assignments to a flat fee. But other brokers are still charging an insanely high agent-handled commission for an option assignment, so it would be a good idea to negotiate one's broker down to a flat fee in advance of such trades.

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humble_pie

· #8 · Sep 16, 2014

it's true, neither a stop nor a call is going to be precise as to the date & as to the penny.

the only precise mechanism is to sell the stock at a price that is reasonably within the market BA range.

this is not maybe-sell-the-stock-if-some-contingencies-fall-into-place.

say stk is at 52 & falling; mid & long-term MAs have been crossed; outlook is doubtful.

but still our investor dithers, he can't make up his mind to sell. Maybe he likes the dividend? nobody knows for sure, least of all our investor.

does it matter whether he enters a stop at 50 & may get taken out at 48.90 or maybe not at all; or whether he sells a $50 call for 2.58 & may get taken out at 50 or maybe not at all.

my point was only that he who dithers can choose to dither for a few extra shekels, if he likes.

of course, if he wants to stop dithering, an investor could put on a collar. This is a short call + long put combo.

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Woz

· #9 · Sep 16, 2014

Given the scenario you describe, selling a call for a few extra shekels could be costly. If STK continued to fall to $40 then the investor who entered a stop loss would’ve sold STK at $48.9 limiting his loss to $3.1. For the investor who sold a call, the call position wouldn’t be exercised and the investor would be stuck still holding the stock at $40.

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humble_pie

· #10 · Sep 16, 2014

Woz said:
Given the scenario you describe, selling a call for a few extra shekels could be costly. If STK continued to fall to $40 then the investor who entered a stop loss would’ve sold STK at $48.9 limiting his loss to $3.1. For the investor who sold a call, the call position wouldn’t be exercised and the investor would be stuck still holding the stock at $40.

our friend might be a ditherer but surely he is not demented enough to twiddle his thumbs & do nothing while his stock plummets to $40?

please keep in mind that he received 2.58 for selling a 30-day $50 call when stk was $52. So he's protected on the downside to $47.42.

by the time stk plunges below the 47.50 level, that call option will be close to worthless. Its near-expiration time value will be decaying harder & faster than the stock can fall.

our ditherer will have to buy back his short call to close but probably he can do this for $.40-.45. He'll be out at 47.05 for a net sale of $49.63, clearly ahead of his stop loss friend at 48.90.

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