Q. When is the use of stop losses not appropriate?
A: Using protective stops to manage risk has downsides especially in volatile markets but then there are pluses and minuses to every risk management strategy – the important thing is to have some sort of plan in place that prevents you from experiencing large portfolio draw-downs. Using protective stops on individual stock positions is one way of achieving this objective and is probably the best approach for short-term traders. However, it is certainly not the only way to manage risk and is not, in my opinion, appropriate for value-oriented long-term investors or those who speculate in securities that don’t offer good liquidity.
Undeniably, ‘The use of protective stops – i.e. the determining of price levels, in advance, at which you will exit if the market moves against you – is a popular way of managing risk. In fact, it may be the best way for most short-term traders to manage risk and is almost certainly the best way for traders of commodity futures to manage risk. There are situations, however, where it makes no sense to use a protective stop.
One such situation is where valuation is the primary basis for the purchase of a stock. If you buy a stock on the basis that it is being under-valued by the market then as long as the underlying fundamental story remains intact it will make no sense for you to sell in response to a price decline (a price decline will simply cause the stock to become even more under-valued). No sense, that is, unless you aren’t really confident in your valuation analysis, in which case you probably shouldn’t have bought the stock in the first place.
It will generally also be inappropriate to use ‘stop losses’ to manage risk when dealing in securities that aren’t particularly liquid. Many junior resource shares, for example, routinely make large moves in response to incremental changes in stock supply/demand. In order to avoid being ‘whipsawed’ the buyer of such stocks would therefore have to set his/her ‘stops’ so far below the market that the stops would not serve their intended purpose (the intended purpose being to ensure that any loss will be a small loss).
Q. Is it a good idea to hold on to losing short-term positions and trade for a longer timeframe?
I realise that most people set a stop loss close to where they open a position. But what if you are making short term trades over a timeframe of minutes and you open a position expecting the price to rise but instead it goes down.
If over a larger time frame(say 30 minutes) the trend looks like it’s definitely down and the indicators are suggesting that, do you ever decide to allow your trade to go on for a longer term trend, rather than just cutting losses?
A: You got in short term it’s gone wrong, get out, you didn’t enter with a long term view so why have one now you’re doing money?
If you get on the M25 intending to go 2 junctions clockwise but find you’re going anticlockwise do you:
A – Keep going round all 30 junctions
B – Get off at the next junction and get back on the right track
(For those not from the UK the M25 is a huge motorway/freeway that runs around the outside of greater London)
From my own personal experience, I believe moving your stop is a very dangerous thing to do. Not only will this result in violating your trading plan but the temptation is to think, if it continues to move against you, I can’t close it now, I will just wait a little bit more for it to rebound a little. If it continues to move against you, it gets harder and harder to close as you have lost so much more than originally anticipated.
