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Making Stop-Loss Orders Work


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By Leland B. Hevner
President, National Association of Online Investors (NAOI)

Stop-Loss Orders can be a powerful tool for reducing portfolio risk, yet most investors don’t use them today. In this article I discuss why they don’t and show how a new approach to investing, developed by the NAOI, will make Stop-Loss Orders more effective and significantly increase their usage in the future.

As a teacher of personal investing, I interact with hundreds of individual investors every year. I find that when considering portfolio design, a majority of people prefer the goal of protecting their money as opposed to growing it. Risk avoidance has become more important as a result of many individuals having suffered significant losses during the stock market crash of 2007-2008.

In this article I show how Stop-Loss Orders, used in conjunction with a new approach to investing, can substantially reduce portfolio risk without degrading its wealth generation potential.

Dynamic Investment Theory and Dynamic Investments

Via a series of articles posted on this site, I have explained a new approach to investing developed by the NAOI called Dynamic Investment Theory (DIT). You can read how it works in the article on this site at this link. DIT creates a revolutionary investment type called Dynamic Investments (DIs). For convenience purposes I will summarize how DIs are designed and work below:

A Dynamic Investment has the following components:

  • Dynamic ETF Pool (DEP) – This is an area of the DI where designers place multiple ETFs that are candidates for purchase by the DI.
  • Review Period – All DIs are reviewed on a periodic basis as defined by the designer; “Quarterly” is an example. At a Review event, the ETFs in the DEP are ranked by the Price Trend Indicator (see below) to identify the one having the strongest price uptrend over the previous Quarter. This is the one ETF that is purchased, or retained if already owned, and held until the next Review event when the DEP is ranked again and the ETF held is subject to change.
  • Price Trend Indicator – This is the indicator used to rank the ETFs in the DEP to find the one with the strongest upward price trend.
  • Trailing Stop Loss Order – This is a brokerage order placed in conjunction with the ETF bought, or held, at a Review event. It automatically sells the ETF should its price drop by a designer-specified percentage during the short time that it is held between Review events. 7% or 10% are typical.

You can see the Dynamic Investments are a comprehensive investment type. They not only specify the ETFs to work with but also how they are to be managed on an ongoing basis.

Stop Losses (SLs) and Trailing Stop Losses (TSLs)

As explained above, DIs own only one ETF at a time and this can be risky. But much of this risk goes away with the use of Stop-Loss Orders and more specifically Trailing Stop-Loss Orders.

Stop Losses do exactly what they say. When you place an order for an equity you can place a related order that automatically sells it if its price drops by a percentage, or dollar amount, that you specify. Thus if you buy an Exchange Traded Fund (ETF) - SPY for example - for $100 you can place a Stop-Loss Order to sell it should it drop by 7%, which would set the automatic sell price at $93.

In my opinion, a better order type for this purpose is a Trailing Stop-Loss Order. A TSL’s automatic sell price moves up with the price of the equity it is attached to. Thus, using the above example, if SPY moves up from the purchase price of $100 to $105 the TSL’s sell-trigger moves up to approximately $98, maintaining its 7% drop limit.

TSL sell prices move up but they don’t move down. So, if after reaching 105, SPY goes down to 103, the TSL trigger price stays at $98. Only if the price of SPY goes above 105 will the TSL trigger price go up again. Should SPY go to $107.5, the TSL sell trigger moves up to $100, your purchase price, and this becomes a risk free trade.

Why the Use of Stop Loss Orders Is Rare

You can see how TSLs not only reduce the risk of a trade but also how this risk decreases as the related equity’s price goes up. So why doesn’t everyone use them? Let’s look at the reasons.

The Dangers of “Whiplash”

A major problem with Stop-Loss Orders is that they can sell your equity when its price drops to the automated sell point and then the equity begins to rise in price again. So you have taken a loss and you miss out on a continuing price uptrend. This is called whiplash and can easily happen if the TSL’s automatic sell price is set too close to the purchase price. The following example SPY price chart illustrates this problem.

On this chart SPY was bought at $100, as shown at point “A” on the chart, and a TSL was placed on it with a sell-trigger at 7% below the purchase price. The original sell-price is, thus, $93 as shown on the left side of the chart. The chart illustrates what happens should the price of SPY rise, fall and rise again.

In this example, after SPY was bought at $100, its price rose to $105. The TSL sell price rose with it to $97 which maintains the 7% drop sell-trigger. Then the stock fell and a TSL sale was triggered at $97. So, you lost $3 per share on this transaction and you are out of the market.

Then, in this example, SPY goes back up in price to above the previous high of $105. You will miss out on this, and further price increases unless you buy it again. But at what price do you repurchase it and where do you set the automatic sell price for a new TSL? It all gets very complicated.

This type of action is called “whiplash” and it is a major reason why Stop Loss Orders are not used by most investors today. In this example it would have been more profitable to just hold on through the price dip.

But what if the price decrease wasn’t just a temporary “dip”? What if this was the beginning of a much more significant loss or even a crash? Then the TSL would have been a life-saver.

Today there are no good answers to these questions. Modern Portfolio Theory (MPT) methods give us no tools for making effective decisions related to if or when to place Stop-Loss orders and where to set price sell-triggers. But Dynamic Investment Theory does. Let’s see how.

TSLs in a DIT Environment

DIT methods enable investors to take advantage of the loss protection benefits of Trailing Stop-Loss Orders without the fear of whiplash. I illustrate how using the following two charts.

Scenario 1: Whiplash

Using DIT methods you would not just buy SPY and hope for the best. You would buy a Dynamic Investment with SPY and a Bond ETF – perhaps EDV - in its Dynamic ETF Pool (DEP). The DI is reviewed periodically, e.g. quarterly, and the one ETF in the DEP moving up most strongly is purchased (or retained if already owned) and held until the next Review event. The Review events for this example are shown at the bottom of the chart. Let’s look at the action points shown on this chart.

Point A. At Review 1 SPY is trending up more strongly than EDV so it is purchased and a TSL is placed on SPY with a 7% drop sell-trigger. This is exactly what happened in the previous chart.

Point B. Also, the same as the previous chart, SPY is sold at $97 and the DI is out of the market sitting in cash.

Point C. Using DIT methods, at Review 2 the DI buys SPY again because its price is rising more strongly than EDV. So the DI got you back into the stock market very quickly, minimizing the effects of whiplash and you will continue to take advantage of SPY’s price increases. There are no subjective decisions involved here – all trade signals are based on objective observation of price trends.

Scenario 2 – Stock Prices Continue Down

What if SPY’s price drop was not temporary but rather the beginning of a significant downtrend? Let’s look at how your DI would automatically handle this situation using the chart below.

Here are the DI action points on this chart.

Points A & B.  These action points are the same as those shown on the previous chart. SPY was purchased at point A with a 7% TSL attached and sold at point B for $97 when the TSL sell-trigger was hit. Your DI is now sitting in cash until the next scheduled Review.

Point C.  At point C, the next Review event takes place and, unlike the previous charts, SPY is still dropping in price. History tells us that if Stocks are dropping, Bonds are likely risking – e.g. they are non-correlated. So odds are good that when the DI ranks its DEP at Review 2 it will find that EDV is moving up in price more strongly than SPY in which case EDV is purchased and held until the next Review. A TSL is placed along with it using a 7% drop sell-trigger.

In this scenario the SPY Trailing Stop-Loss Order stopped losses quickly and waited in Cash until Review 2 when the DI purchased the uptrending EDV. Again, no subjective judgments were involved here.

The Difference

From these simple examples you can see why Stop-Loss orders are safer and more effective using DIT portfolio management methods instead of the MPT methods that are in universal use today.

Working with MPT’s buy-and-hold portfolios the use of Stop-Loss orders requires an investor, or advisor, to essentially guess at where to set the Stop Loss sell-trigger. If it is set to low, whiplash can occur as the equity is sold and misses out on continued gains. Then the investor must decide whether the equity should be bought again, and when. MPT provides no guidance for answering these critical questions and risky subjective judgments must be used.

DIT methods do provide guidance for questions related to Stop-Losses. First, the % drop that triggers an automated sale is not as critical as it is an MPT environment. If whiplash occurs, it is remedied at the next Review event when the stopped-out ETF can be purchased again if its price is moving up. If the equity price continues to go down, the TSL limits losses and at the next Review event another ETF from the DI’s DEP that is moving up in price is purchased. This trade decision is automatic and involves no subjective judgments.

The major difference between MPT and DIT methods is that DIT sets specific rules for entering and exiting positions based on a periodic sampling of price trend data, thus enabling Stop-Loss orders to work extremely well. MPT does not provide investors with an equity entry/exit plan, making the use of Stop-Loss Orders a guessing game at best and too often ineffective.

Summary

In this article I have explained how Stop-Losses used in conjunction with Dynamic Investments become far easier to use and significantly more effective than they are today using MPT methods. As a result, in a DIT-based future of investing the use of Stop-Loss Orders will skyrocket as investors add this powerful risk-reduction resource to their investing toolkit. And these investors can strive for higher returns than they passively accept today.

When we break out of the MPT “box” that we are in today and use DIT investing methods, the world of investing becomes a friendlier and more profitable place to invest. You can review other benefits of this new approach by reading my other articles found at this link.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.





This article appears in: Investing , Investing Ideas , Financial Advisor Center , Stocks



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