The Power of Stop Loss Orders

I don’t make many short-term trades. Most of the times I have opened and closed a position within a matter of days, I will admit that I got lucky. I’ve written about trading market catalysts before in my article about the annual Federal Reserve bank stress tests. Back in 2009 I bought Fifth Third Bancorp just prior to the stress test results. Here’s an excerpt from my book:

On Monday, April 27, 2009, I bought shares of FITB at $3.64 per share. By the close of the trading day on the following Monday, FITB was over $4.50 per share, a gain of nearly 25% in a week. On Thursday, May 7, the Federal Reserve released the results of the stress test. Ten of the 19 banks “failed” the stress test, indicating that they would need to raise additional capital. Among the flunkees were Citigroup, Bank of America, and FITB. Fifth Third needed to raise an additional $1.1 billion dollars, which was a lot of money for a relatively small regional bank. So what happened to my bank stocks? The week of the stress test results, C and BAC jumped over 30 and 60 percent respectively! And FITB? My FITB shares rose a whopping 110% in one week! All of these banks had “failed” the stress test, but the results were not the end of the world, and investors were relieved to see some light being shed on the situation. At the time, I was well aware how absurd it was that a stock would double in a week, and I was worried that there would be selling pressure to drive FITB’s share price back down. On Friday, May 8, less than two weeks after I bought my FITB shares, I sold them for $7.28. In case you didn’t notice right away, that is exactly TWICE what I paid for them! I had doubled my investment! 

Now, the difference between what I did and what a typical short-term trader would have done in that instance is intention. The short-term trader would have bought that stock prior to the stress test results, anticipating a rise in share price from the catalyst. No matter what happened, the short-term trader would have exited the position within a week and would have taken whatever return the catalyst produced. My intention, on the other hand, was to make sure that I bought this undervalued stock before the stress test to insure that I was able to buy it at a good price. Just like the short-term trader, I was hoping that the stress test results would produce a spike in share price, but unlike the short-term trader, I wasn’t planning on selling FITB until the stock reached a decent valuation. If that took a month, I would wait a month. If that took a year, I would wait a year. I never predicted that the stock would double in a week, and when it did, I sold it and took my profits.

I recently discussed the 20% or so of my portfolio that is devoted to short-term technical trades. Motley Fool doesn’t like it when I talk about short-term trading or technical analysis, so this stuff is exclusive content… As I have said before, the critical part about these short-term momentum-based trades is that you limit your risk. The way I limit my risk on these trades is by using stop loss orders. From my book:

A stop sell establishes a price lower than the current market price at which your order will be executed at market price. Stop sell orders are often referred to as stop loss orders because they put a cap on the amount of losses you will endure if your stock starts to decline. For example, if I buy Company X at $72.50 hoping it will go up, I might put in a stop loss order at $69.00. The idea here is, if I am wrong and Company X goes down to $50.00, I would have avoided the majority of the losses because my shares would have been sold at market price as soon as the price hit $69.00. 

Stop loss orders are almost always a good idea. Even when I don’t place an actual stop loss order, the first thing I do in my head after I buy a stock is ask myself, “If this thing starts to go south at any point, at what price am I jumping ship? Or am I willing to ride it down to a watery grave?” And no matter how confident you are in your purchase, if you don’t think that disaster can strike at a moment’s notice, go find some Bear Stearns shareholders to talk to.

So any time I buy a stock based strictly on some technical pattern  or momentum I’ve seen in the charts, the first thing I do is slap on a tight stop loss order, often within 5% of my purchase price. To me, the best thing about stop loss orders, and particularly trailing stop loss orders, is that they allow your trade to have a defined, limited risk without any restrictions on your potential upside. Again, from my book, here’s how trailing stop loss orders work:

When entering a trailing stop sell order, you will pick a stop price that is below the current market price, and as the market price rises, your stop price will rise along with it. For example, say I buy Company X at $72.00 and place a trailing stop sell order at $69.00. After I place my order, the price of Company X rises to $75.00. Since the market price of Company X raised $3.00 per share, my trailing stop price would have risen $3.00, and my new stop price would be $72.00. If Company X’s stock price continued to rise, my stop price would continue to rise along with it, always “trailing” it by $3.00. However, the first time that the price dropped $3.00, my sell order would be executed at market price.  

So here’s an example of the power of limiting your downside while keeping your upside unlimited: of my last 10 short-term momentum trades, I’ve profited off of 5 of them. That means that I’ve been wrong half the time. That’s not great. However, because of the power of stop loss orders, the five losses have been small ones. In fact, as of today’s spectacular earnings report, my position in Micron is up about 24% in less than two months. Even if I subtract the losses of my last six losing trades from the gains on Micron alone, I still have a large profit overall.

Take a minute to appreciate the beauty of that situation: because of the power of stop loss orders, I can lose money on half my trades and still make a large net profit because the losses are capped and the gains are not. If I’ve said it once, I’ve said it a thousand times: limiting risk is as important as picking winners if you intend to be a successful trader.

Want to understand how to make money in the stock market by identifying ways to reduce risk in your portfolio? Or maybe you just want to be able to look sophisticated in front of your coworkers when they ask you what you are reading on your Kindle, and you’d prefer to tell them “Oh, I’m just reading a book about stock market analysis,” rather than the usual “Oh, I’m just looking at pics of my ex-girlfriend on Facebook.” For these reasons and more, check out my book, Beating Wall Street with Common SenseI don’t have a degree in finance; I have a degree in neuroscience. You don’t have to predict what stocks will do if you can predict what traders will do and be one step ahead of them. I made a 400% return in the stock market over five years using only basic principles of psychology and common sense. Beating Wall Street with Common Sense is now available on Amazon, and is always available on your local internet!