Newspaper article Sarasota Herald Tribune

Stop-Loss Orders: Technique to Save or Widely Held Myth?

Newspaper article Sarasota Herald Tribune

Stop-Loss Orders: Technique to Save or Widely Held Myth?

Article excerpt

THERE ARE MANY SHIBBOLETHS in the investing world. To name just two: "Sell in May and go away" and "As January goes, so goes the year."

Unfortunately, the data does not support either. For example, the data show the average returns from June, July and August are higher than any other three consecutive months, and that when the market is down in January, it's about just as likely to be up as down for the rest of the year.

What about stop-loss orders, widely touted as effective at saving investors' money? Are they a reality, or just another shibboleth?

Let's review the basics.

A "stop" is a price the investor sets with his broker that's below the current market price. If the stock's price falls to that price, the investor wants the stock sold.

This is implemented by the broker using a stop-loss order. When the stock's price falls to the stop, the stop-loss order is converted to an ordinary market order to sell the stock at the best price then available.

This simple point is critical to understanding a key flaw of stops.

The main selling point for stop-loss orders is that they appear to give the investor the ability to limit losses on individual trades to a specific amount. Unfortunately, that's not quite what stop-loss orders accomplish.

Since the investor has in effect submitted a plain vanilla market order, she is subject to the normal or abnormal whims of the market. If the bid price fell sharply below the stop, the stock would be sold significantly below the stop price. This is what happened to many investors during the infamous "Flash Crash" of May 6, 2010.

As important is the fact that one day's stock movement has little correlation with the next day's movement. This means that the fact that the stock went down today has no predictive power about what the stock will do tomorrow. The result of executing the stop-loss order might well be selling at the stock's low point.

Additionally, there is no agreed upon way to set a stop. Let's review some possibilities

Suppose an investor bought 1,000 shares of a stock at $88. …

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