Over my 30 years as a broker and investor, I have often heard stock, options, and futures traders (who should know better) and brokers (who REALLY should know better) make the assertion, “I never use stop orders” or the sometimes foolish pronouncement, “I always use stop orders.”
My guess is that misunderstanding the stop order costs the investing public more money each year than half trillion US dollars. Now, of course, I always believe I’ve got a winner when I enter a trade. However, the market, the floor broker, other misguided investors, earnings reports, politicians, the weather, and even a talking head’s negative comment sometime conspire to screw up my sure-thing position.
You have the same problem.
So we all know – or will painfully learn – that prudence requires us to take into account that the market may move against us and we need to limit our risk. The stop loss order is the classic way to limit risk on a trade. But the stop loss order is frequently misunderstood and the failure to really appreciate its limitations as well as its virtues is much to the detriment of the investor.
In some situations, there is a better way than the basic stop order to protect a market position – especially one involving options.
Let’s go over some risk-limitation schemes that: (1) don’t work; (2) often work; (3) work even better than those of group (2). And although the focus of this article is “stop loss orders,” let’s also look at (4) a very useful stop order that has nothing to do with limiting loss.
Whether you are a day trader (Lord help you), a buy-and-hold proponent (you have big problems too… think Enron, AIG, Lehmann Brothers, etc.) or an income investor like those who employ The Monthly Income Machine, you need to really get cozy with the subject of how to truly protect your account from serious drawdowns.
Risk limiting strategies that don’t work
These approaches are so common I have given them their own pet acronyms.
IWI (“I’ll watch it”).
This means, “I check my positions several times a day and I’ll know if it’s time to get out.”
Yeah, right. Be prepared to “watch” your account deteriorate because your exit decisions will be emotional rather than carefully thought out in advance… or you may be walking your dog when something very significant to your position occurs.
ICGAL (“It can’t get any lower”)
“I’m right, so I’m going to ride out what’s sure to be a temporary setback.”
Wanna bet? (again, think Enron, AIG, and Lehmann Brothers to name a few examples of just how low it can go).
SIBSM (“So I’ll Buy Some More”)
Here we take ICGAL to the next level. It can’t get any lower (ICGAL), So I’ll Buy Some More (SIBSM)!
Some pundits try to sanitize this “strategy” by calling SIBSM “dollar cost averaging.” Again, at the risk of being repetitive, think Enron, AIG, and Lehmann Brothers.
When I was a broker, despite my best efforts at stopping them from doing it, I had some clients who employed all three… IWI, ICGAL, and SIBSM. Their accounts were relatively short-lived.
Risk Limiting Strategies That Often Work.
The operative word here is “often.” Stops usually work to limit risk, but their use is often imperfect. The stop order is an arrow that belongs in your quiver, but it is nonetheless an imperfect weapon in the battle against serious losses… especially when misused or misunderstood.
Stop Loss Order (standard, vanilla version)
This is the most commonly used technique for limiting the risk in a position you hold. Simply stated, it’s an order you place that says, “If the price of the stock (or option or commodity or ETF) reaches a particular price, close out my position.”
So long as trading has not been stopped by the exchange for some reason, this order will succeed in getting you out of the market.
What is often not considered by the casual investor is that you will usually not get out at the specific price you set on your stop order. That’s because when the specific trigger price on a stop order is “reached,” the stop order becomes a “market” order and you will receive the best price available at that time… which in some cases can be substantially worse than you were planning on.
First, let’s be clear on what “reached” means with respect to triggering your stop loss order. It is not necessary for the stock to actually trade at the specified stop order price. The sell stop order to exit from a long position will be triggered if just the “bid” price touches your stop price. In other words, you can be stopped out of your position if the bid reaches your stop price, even if there have been no trades at or below that price!
The situation is analagous when exiting from a short position on a buy stop order, except the trigger can be reached by touching the “ask” price.
Here’s a real-world example of getting knocked out of a position on a stop order when you really don’t want to exit from your position. You own 100 shares of XYZ stock you bought earlier at $50.00, and it closed yesterday at $54.00. You have a stop order active in the market to sell the XYZ if the price drops to $52.00.
Today, before the opening, the stock is bid at 52.20 and the “ask,” is at 52.50.
The market opens at 9:30 EST with XYZ bid at $52.00. The $52.00 bid triggers you stop order, which now becomes a market order. The next trade (yours) takes place at $52.10 and your stock is sold at that price. At the end of the day, the stock is up to $56.30. Even though the lowest actual trade that took place was yours at $52.10, the result is that your $52.00 stop loss order took you out of your XYZ position even though the stock never traded that low!
Here’s another situation where your stop loss order does what it’s supposed to do, but not necessarily what you expected or desired.
Again, you own XYZ at $50 and let’s assume it closed yesterday at $54.00; you have a stop order to sell it if drops to $52.00. However, before the opening today, a rumor surfaces that the IRS is looking into XYZ’s financial reports… or that XYZ may need to recall its product for safety reasons. The XYZ stock opens way down at $49.50. Your stop order is triggered and your position is sold out at that price. It turns out though, that the rumor is not correct and the stock quickly recovers.
This situation of being filled at a price below the stop price is called “slippage,” and while slippage usually means a relatively small difference between stop price and fill price, it can be substantial as in this example.
Bottom line: the plain vanilla stop loss order can – and sometimes does – close out your position without the stock having traded at the stop price, or at a price far worse than what you intended to be your risk limit.
The Stop-Limit Order
The Stop Limit Order attempts to enable the investor to be more specific about what conditions are acceptable for closing out his position.
It requires that if the stop order is triggered (the stock is bid, or trades at or below the specified stop price), it can only be filled at the stop price or better.
In the second XYZ situation described earlier, if we were using a $54.00 stop-limit order, and XYZ opened below $54.00, the investor would not be knocked out of his position at the very low $49.50 opening price, but would remain in the position until, and if, the price rose to his stop limit price and would then be filled at that price.
The bottom line for the stop-limit order is that in many cases it can result in your exiting from a position at the exact price point you want for limiting your risk. It is especially useful when the stock in questions is very liquid, i.e. is traded heavily as evidenced by large daily volume statistics and a relatively small spread between the bid and ask price of the stock.
But – and it’s a very big “but” – there is a very serious downside to the stop-limit order you must understand: unlike the case for the plain vanilla stop order, there is no assurance that you will be able to exit from the position at all using this specialized stop. In the rumor-driven $49.50 opening trade example, if the stock opened there and for the rest of the day and subsequent ones just kept going down, the investor – who would still be in his losing trade – would be absorbing a serious loss. In short, his loss could be far in excess of the $54.00 stop limit trigger price he set to try to control his risk.
Using an Option Instead of A Stop Loss Order
If you are using my The Monthly Income Machine approach to conservatively generate monthly option market income, you already know options can be used either for speculating on the direction of the market, or via the Machine’s specific entry rule credit spread strategy as a low-risk vehicle for the income investor.
But even the more sophisticated investor may be unaware of how the unique features of options can be employed to protect his stock and other non-option positions.
Our earlier XYZ stock example (bought 100 shares at $50) has been enjoying a nice rally and is now trading at $60.00, giving us a paper profit of $10/share on our 100 shares. Our long-term outlook for XYZ remains bullish, and we are well above the “technical support” price level. We recognize, however, that a bout of profit taking could easily occur following the recent rally, and that an upcoming earnings report could trigger the profit taking or even tank the stock if earnings proved to be a big negative surprise.
We could enter a stop loss order at $55.00 to protect much of our current profit, but fear that a temporary drop to that level could occur, stop us out, and then we might watch XYZ resume its upward march without us. In other words, we are in a position where being “whipsawed” is quite possible.
A solution: Instead of placing a protective stop order at $55, we can buy an XYZ PUT OPTION with a Strike Price of $55 and an expiration date 2 months from now. Let’s assume we would have to pay $40 for this put option to protect most of our $6,000 worth of stock.
Now we do get a somewhat disappointing earnings report and a well-known TV pundit suggests selling the stock. The stock opens the next day at $54.00. If we’d placed a conventional stop loss order on XYZ stock at $55.00 we’d be stopped out at $54.00, having lost $6 of our prior $10/share paper profit.
In this case, since we still own the stock, the best-case scenario is that the stock recovers and eventually trades back to $60 and higher. If this happens, we are still in the trade, able to participate in any further rise, and our cost has been the $40 “insurance” we paid for the protective put option that enabled us to avoid being whipsawed.
So let’s consider what the net result is if the stock continues to fall, say down to $50. With the stock at $50, we have given back our entire $10 paper profit on the stock. But we also now have at least a $5/share profit on our ($55 strike price) put option. This is because once the price of the stock reaches the Strike Price of the put option, every dollar we lose in the stock from that level, we make back on the option.
Thus, with the stock now at our original entry price of $50, we’ve given up $10/share paper profit from its $60 high on the stock and gained $5/share (on paper) on the put option. Thus we have a $5/share net paper profit on our original investment in the two positions. No matter how far down the stock goes below our put option Strike Price of $55, our net result of a $5 profit remains the same.
BUT, we still have the stock, and while we can’t give up any more profit if the stock continues to decline, we do participate fully in any subsequent rise in the price of the stock!
And Even Better – Let’s Have the Market “Pay” for Our Protective Put Option
While using a put option can be a fine protective strategy for a stock position, here’s the icing on the cake:
In addition to buying a put option with a Strike Price below the current market to protect our stock, we ALSO can sell a call option with a Strike Price above the current market to give us some additional income to pay for the put option protection!
Here’s how it works. With XYZ at 60, we bought a 55 put option to protect our stock because the put option gains in value as the stock itself loses value in a decline. The premium paid was $0.40 for our insurance put option.
Now, let’s simultaneously sell an XYZ call option with a Strike Price of $65. Let’s assume the premium we receive on the sale of this call option is also $0.40, the same amount we paid for the $55 Strike Price put option. Now our net cost for the “insurance” of the put option is ZERO.
Everything remains the same as described earlier if XYZ goes down. If, instead it goes up and reaches $65 or higher on option expiration day, our stock will be “called away” with us receiving $65 per share… and we also keep the $0.40 premium we received when we sold the call, so it’s as if we are selling the stock we purchased at $50 for $65.40.
If the stock goes up, but doesn’t reach the $65 level on expiration, we keep the stock, and, as always, we keep the $0.40 premium we received for selling the call.
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