The market is bouncing up and down like Marqeus Haynes dribbled a basketball. Are stop losses necessary?
Investors are edgy. Money and Markets reports - "Alarming Survey: Record Number of Fund Managers More Bearish than 08 Crisis".
"…. Bank of America's monthly survey…is warning investors to take caution and heed the market's warning signs.
…investors managing about $646 billion in assets completed the survey, and a record 85 percent of respondents said the global economy is "late-cycle".
Can you time the market?
Everyone wants to buy at the low point and exit at the top. If you do, you are lucky!
During the tech boom my broker and I both bought a high-flying stock. We watched it double twice. It hit $100; we were sitting on nice gains.
Suddenly it dropped to $80. We talked about getting out - but decided to hang on. We were rewarded; it went back to $100. It did it again - then it hit $75.
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It continued down. Each discussion ended with, "It can't go any lower!" We kicked ourselves, feeling stupid, wishing we sold earlier. We finally capitulated, losing much of our profit. Yes, it can go lower - it bottomed around $4.
Much of today's market is automated computer trading. Money managers tout their sophisticated tools reassuring investors they have programs to protect against catastrophic losses. They reassure investors about being safely diversified in their "family of funds".
Gillian Tett warns , "The top 1% of mutual funds have 45% of the assets."
Bloomberg reports, " JPMorgan Sees $7.4 Trillion Passive Selling Pressure in Downturn ".
"That's the warning from JPMorgan Chase & Co., which says $7.4 trillion of assets managed by passive funds around the world - concentrated in large-cap and U.S. small- and mid-cap stocks - will exacerbate a rout during the next recession."
More than passive funds will be in big trouble. Funds will have a liquidity crisis like we have never seen before. Those with individual stocks may be able to liquidate, but at what price? Investors will learn "diversification for safety" is a lot more than a "family of funds" in the US stock market.
The Guardian warns , "…as part of the International Monetary Fund's annual economic outlook, it warned that ' large challenges loom for the global economy to prevent a second Great Depression '". (Emphasis mine)
A Great Depression is not a "rout", it's annihilation!
Does the individual investor stand a chance?
Yes, I think so, if they heed the warning signs, not hanging on hoping to time the market.
At Casey Research, we had a model portfolio. Diversification of your portfolio means equities, gold, foreign currencies, and much more.
We recommended that no individual stock should be more than 5% of your portfolio, rebalancing regularly. We recommended 20% stop losses. Theoretically, the worst that could happen is you could lose 1% of your stock portfolio if one stock cratered.
Understanding Stop Losses
A stop loss is a sell order placed with your broker - if a stock hits a predetermined price. The goal is to prevent catastrophic losses.
When you buy a stock, determine how much you are willing to risk and enter the order at that time. If you bought a stock at $100, and want a 20% stop loss, you tell your broker to sell if the stock drops to $80.
That's the theory, however…
Below is a screenshot from my computer trading screen.
I entered the name of the stock and clicked SELL. I clicked on the arrow under ORDER TYPE. The first two choices are for selling today. The last three choices, Stop, Stop Limit, and Trailing Stop are different types of stop losses.
STOP - Using the $100/share example - click STOP. Enter your price, $80 and the timing is GTC (Good Until Cancelled) - theoretically. Schwab automatically cancels the order after 60 days, you have to keep them up to date. (I update them monthly, it's easier.)
If the stock drops to $80, a sell order is entered at the current market price . You are not guaranteed $80, you sell at the market price at that moment. Most of the time you get $80.
However, the stock may have closed the day before at $80.50. Some bad news was released overnight and the opening price the next day could be below $80. Your order would be executed at the current market price.
STOP LIMIT - This order protects your price but doesn't guarantee a sale. Using the same example. If the opening price is $79.50 your sell order would NOT be executed unless it can be sold for $80.
Many investors prefer a STOP LIMIT order for volatile stocks or a volatile market. If the market opens below your price, it gives the investor time to review what is happening. Is the "plunge protection team" going to rally the market? They can cancel the current order, choose to enter a sell order, hold on, or perhaps buy more.
Why would you buy more if a stock craters? The Street.com reports, " Companies that Suffer a Data Breach See 42% Slide in Stock Price ". Savvy investors jumped on Target stock a few years ago when that happened.
If JPMorgan is correct, programmed traders can trigger a market crash so dramatic, computers may not have time to execute a trade.
If the broker can, they will sell the stock at $80, unless the order is canceled. If it jumps lower, each investor should review the situation and decide the best course of action.
TRAILING STOP - This is my favorite. When you click TRAILING STOP the computer asks for a percentage.
Using our $100 stock, you may choose 20%. As the stock price rises the trailing stop follows. If the stock rose to $120, then dropped 20%, (to $96) the computer enters a sell order at market price. Your loss would be $4/share.
Had I used a trailing stop on our tech stock I would have saved a lot more profit.
It is fun when your trailing stop exceeds your cost. Your trailing stop is then protecting profits.
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Holding On To Gains
Subscriber Rick G. asked when I decide to sell. Unless there is a compelling reason, I seldom do. If I feel a stock is getting ahead of itself, I tighten up my stops, perhaps 10% or less. I'm willing to risk a small portion of my gain hoping the stock will continue to climb. If stopped out, I'm happy with a nice profit. A catastrophic loss is an unforgettable experience, it leaves a mark!
When is it better to NOT use a stop loss?
Stop losses don't work well for every investment.
The "market maker" is not our friend . The market maker is required to make a market, bringing the buyer and seller together and taking a commission off the top.
If you enter a buy order for $20.50 and a seller enters at $20.48, the market maker will execute both orders and pocket the difference.
Your stop-loss orders appear on their screen and they can take advantage of you. If you ever get stopped out at the low price for the day, there is a good chance the market maker nailed you.
In the early days of computer trading I put in a buy order for a stock at $20.25/share, under the current market price. I saw the order pop up on my computer screen. I was first in line if the price dropped. When it did, several hundred shares traded, and my order was not executed. The price jumped back to $20.50.
I asked my broker what happened. Ten minutes later, with the market still at $20.50, my order was executed at $20.25. I was told, "The market maker apologized, he just missed it." Baloney! He hoped the price would drop lower, so he could skim off a couple pennies for himself - on top of his commission.
Do not use stop losses with highly volatile or thinly traded stocks, it is too easy to get stopped out by an aggressive market maker . I don't worry if several million shares a day are traded. A market maker might skim a penny or two, ($2.00 on 100 shares?) but my trade will be executed at my stop loss price.
Stop loss alert - My trading screen has a tab for ALERTS. It instructs my broker to alert me when a stock hits a certain price.
There are also private companies that notify customers by text, phone or email. Active traders use these companies regularly. If you have any reservations about being nailed by a market maker, use stop loss alerts .
I recommend using stop loss alerts for mutual funds.
We can't control the market, but investors have plenty of tools to avoid catastrophic losses - if they are paying attention. I received three notifications this week from newsletters advising subscribers they were stopped out of a particular stock. While that's good, stay proactive and set your own stops where appropriate. It's better to sell a year early at a profit than a day late with a loss!
If you get stopped out, never look back…the system worked, you preserved capital and lived to fight another day.
This article originally appeared on MillerOnTheMoney.com .