COST
AND BENEFIT OF USING STOP-LOSS
The use
of Stop-loss has its merits, and problems too. Let us take two
examples to illustrate cost and benefit of it.
Let us assume
someone bought a stock like, CMGI or ARBA, around 150$-level
during the Year 2000 boom period, thinking that it was a great
company (Believe me there were many investors who believed so
at that time!). And if he continued to hold to that position
during its downtrend (hoping that it would one day reach 200$!!!),
he would have seen the stock price drop to as low as 1$ in 2002!
In this kind of situations, one would wish if he had kept a
Stop-loss and limited his losses to 5 or 10$ per share! This
makes a strong case for the use of Stop-loss.
Now let
us look at an opposite situation. Assume that the same person
had bought Yahoo at split adjusted 10$ in October 1997 and kept
a Stop-loss at 9$. Suppose the price went below 9$ and triggered
his Stop-loss. He would be out of Yahoo! Position at a 100$
loss! Then as time passed, Yahoo kept climbing up and ultimately
reached as high as 500$ in January 2000! An initial 1,000 $
investment could have been worth 50,000$ if there were no Stop-loss
were used!
Should
A Trader Use Stop-loss?
So a million
dollar question is: Should you use Stop-loss or not? Answer
is that it depends. If you are an investor with purely long-term
perspectives and with a diversified portfolio, you should probably
not.
As the saying
goes, there is no free lunch in financial markets. So the use
of a Stop-loss has its benefits and problems. In a few paragraphs
below, I will try to show you how to get the maximum out of
this Stop-loss and how to use it in your favor. Let us go back
to the above two scenarios one more time.
Let us assume
that that 1000$ position in Yahoo at 10$ price had no Stop-loss.
Do you think the buyer would have continued to hold onto it
until it touched 500$? It is very likely he might be out before
it even doubled or tripled! I think most of the investors including
myself would be pretty satisfied to have doubled or tripled
our investment over a short period. Let us assume our buyer
of Yahoo in this example is made of different material. Suppose
he had guts to hold on to a winning stock and he watched Yahoo
go up to 20, 50, 100, 150, 300$ level. I am curious to know
what would have prompted him to sell Yahoo around that 400/500$
level. It is possible that his patience and guts may have glued
him to that Yahoo position, even when the YHOO stock reversed
its trend and price touched 10$ level back sometimes in 2002.
This is an extreme example and I have mentioned it to highlight
two things: Most of the investors get satisfied with small profits,
and a new type of Stop-loss- Progressive Stop-loss that
we will discuss later in this chapter.
What in
the case of CMGI or ARBA? It is very likely that individuals
who usually take small profits might have stayed in such losing
positions all the way to zero! My point is: Most individuals
play stock market like a D or F-grade student! When it comes
to booking profit, they get easily satisfied with a few points
of profit but when it is a loss situation loss, they are likely
to hold on and stick to the stock too long. Most investors are
more risk-averse (they hate the risk of profit going down) in
the profit zone and less risk-averse (they tend to take a lot
of risk in the hope that prices will go up someday) when in
a loss zone. This asymmetrical behavior is typical for most
investors. What is the end result? Small profits but big losses!!!!
This is the reason I advise most traders to use stop-loss when
they are trading stocks or Futures.
It is very
much feasible that (small) profits in ten positions can easily
be wiped out by two/three big losses! So even if a trader has
70 to 80% success rate in stock selection, we would hardly break
if he does not stop his losses! I think this is one of the main
reasons why our trading results in losses most, if not all,
of the time! I think this makes a solid case for every trader
to understand and learn to use a Stop-loss on every trading
position.