The market is showing a lot of strength right now. I am happy anytime I see client account balances working higher. I hope it continues. I've written a few times that turn arounds often happen for no real reason. Maybe we could piece together an explanation but I would say the market turned because it did, if you follow my sometimes fractured logic.
So many people seem to be changing there tune about bonds lately that it is almost contrarian, now, to call for higher rates this year. For a while I have been saying the next big move will be up for rates (I realize there is nothing insightful there) but I have given up trying to figure out when.
Lastly I had an email that followed up to my Grit your Teeth article earlier in the week. The reader asked about 8% stop orders recommended by William O'Neil. This was my answer.
The answer to your question, I think, depends on what you are doing strategically with your account. For someone that has a bunch of stocks and they are looking to trade out on a, for example, 10% rise then some sort of stop order makes sense. I have not read O'Neil's book so I'm not sure why 8% is as opposed to 7% or 9% but some sort of consistent exit strategy is right.
If you have a diversified portfolio where you are trying to capture all parts of the market I could see where an arbitrary stop order could be the wrong thing. For example lets say you decide that you want to own China through one of the oil stocks as a long term theme, say 5 years. Chances are your would research the names and buy the one you thought was best. Now lets say all of them go down exactly 8% and you get stopped out on your stock. What do you do next? Would you give up on a five year theme because of a bad couple of weeks? Would you then buy what your first research lead you to second best? What if it goes down 8%, you get stopped out and the next day it is up 3%.
Stop orders are not the be all end all. I am not a fan of arbitrarily putting the same stop under every stock. 8% is a lot different in a name like Ask Jeeves than in Proctor & Gamble. Why is 8% right for both names? It might make sense to have a tighter stop on PG and give ASKJ a little more room.
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2 comments:
Roger,
Good analysis and answer to the question regarding stop orders. While Bill O’Neil is a leading thinker for investors and traders alike through Investor's Business Daily and his books, I find some problems with a static 8% stop order. I agree with your assessment of matching the volatility of the underlying stock with the distance between the current price of the stock and the initial stop order. This is critical to manage risk while still allowing for positive movement in your holding. It is also important to incorporate an investor's time frame into the decision making process. With a longer period, generally more flexibility is needed, so the stop order should be placed farther from the current price than with a shorter period. I also agree with stop orders not being "one stop shopping" for investor's risk management needs. Stop orders should be a component of one’s risk management strategy. Others may be selling short indexes that resemble holdings, and various protective options strategies may work as well. One note: With the advance of technology, there are some interesting automatic methods for monitoring and managing risk. One such example is the trailing stop function that some firms offer on their advanced software platforms. This function allows for a conditional order to “trail” around the stock price by a preset amount. I am most familiar with Charles Schwab’s offering and it was upgraded to be set to good til cancelled. In essence, it does what we would all like to do, cut losses at some point, but let winners run while still maintaining an amount of risk management. Now we can all be in the Bahamas, while having a risk management strategy in place…
Misunderstanding Stop Losses
… stop losses are only one element of an exit strategy
Stop losses are critical for any investor. But setting them arbitrarily is out right silly, if you “stop” to think about it. Every investor and every trader needs an exit strategy and execution tactics. That sounds good but the problem is almost nobody knows how to build a comprehensive system with a simple set of rules. Rules are crucial to execution but more importantly they take emotion out of the investment equation. It is fear and greed that leads to poor entry and exit decisions so removing emotion from execution is absolutely crucial. Emotional investing is another word for self destruction. Setting stops is an attempt to deal with emotion but it is only one cog in knowing when to sell. To trade or invest well mentorship in some form is nearly always required. Using an arbitrary percentage of purchase price as a solution to knowing how to protect your self and your capital is to misunderstand exit strategy. Albert Einstein said make a matter as simple as possible but no simpler. Discussing stop losses as asked by the question of “8% stop orders” is to make the matter way too simple.
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