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A question that I often get asked, especially when discussing my investment strategies is why I use stop trades. In case you are not aware, a stop is a price at which you will exit a position. There are many different ways to use them but in general I like to use them in a very clear manner. What do I mean? For example, on most long and short tech stocks that I enter, I use a 20% stop loss limit and a 20% stop gains limit.
That does not mean that I will never lose more than 20% on a trade though. Some events such as earnings can move stocks significantly and a stock could lose or gain 10-20% in an instant. When that happens, there is no way to limit the loss. For example, if I have a trade that stands at -17% and the stock that I am long loses 10%, I will be unable to limit my loss to 20%…
If The Loss Is Not Limited To The Stop Loss, What’s The Point?
The primary objective here is not to limit the loss to a certain amount but rather to gain some extra discipline while trading. Imagine yourself entering into a casino to play Black Jack or roulette or almost any other game. Look around you, you will see many people winning that come into the casino and start winning money. How do they react? It comes very easy to “get caught in the game”. What do I mean?
Losers think that they’ll be able to win back their losses so they put in a bit more. Winners feel like they have the momentum and the luck and they will be able to come home with lots more money. It becomes so easy to be overly optimistic and that can often lead to bad results.
I’d be curious to know how many of those end up playing long enough to lose everything they won and more. I would think though that players that come into a casino with a more specific plan on how they will play, how much they are willing to put in and when they will get out would generally do much better.
A Few Years Ago.. My First Trade
Some time ago, I did my first trade. Not only did I buy into a company but I actually decided to buy an option, a long term call on Yahoo (YHOO). Believe me, I had no clue what I was doing, I probably was more a gambler than an investor but I believed in the company at that point and wanted to get exposure, options gave me that opportunity.
So I bought a few options and in the following weeks, the value of those options increased rather quickly and even ended up doubling. I was asked by friends (who I was bragging to of course) when I would get out. I had no idea. Initially I though I would with a “decent” profit, whatever that means. At some point, those options had actually doubled in price and it was a successful trade… I never did end up getting out and eventually the option became worthless
I Am So Lucky That Happened!!!
It thought me a valuable lesson. Always have an exit. You might argue for an exceptions when you are investing for longer term (such as your retirement). I would argue that even those should have limits. You can simply put the limits a bit further if these are longer term limits.
Do You Use Stop Losses Or Stop Gains On Your Trades?
If not, how do you determine your exit points?
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Stop loss will produce mix results, however, one thing is for certain, you will never ride a stock to zero; which saved at least six positions of mine…
We use a tighter stop of 5 to 10%, which means of course we are stop out more often, but limit our losses…
We never use a stop gain, but rather a trailing stop or the 20 or 50 DMA…
@Hans – Not a bad idea, how would you apply it to a long short position?
I haven’t been using stops lately, because I am long-term in most of my positions. (I’m an accumulator more than a trader.)
However, back when I was using stops, I noticed that I was getting punched out at the worst possible times. I soon learned that desk traders could see those stops and would bid down to poach my positions. So, now I use stop limits, which don’t trigger until the price is reached.
@Bret – on what type of products were you doing this?
Perhaps a stupid question! If you are invested in a good dividend stock paying a good dividend and has been for 10-15-or 20 years, why put a stop on it. Does not the history in most cases give you the quality you want?
jz
@Jerry – Good question, I guess one possible reason would be that if the stock is declining a lot, it could be a bad sign for that dividend as well. But I would use stops that are further away