The use of stop losses is one of those issues to which there is no absolute answer; the truth is that using stops can sometimes prevent a small loss from becoming a larger one, while there are definite risks with using stops; each investor must decide for himself when and in what way to employ stops.
Here at A.D.A.M., we tend to be somewhat cynical on the use of stops. First, automatic stops can be employed for the most part only on stocks listed on U.S. exchanges; they cannot be used on Nasdaq, for Canadian stocks, and on most other foreign markets.
Second is the important consideration of being whipsawed, wherein a stock declines to the stop level, takes you out, and then reverses and moves back up. (It is widely thought that some speculators will take stocks down to prices where there are batches of stops.) This is particularly, but not only, true of volatile stocks. Had we employed stops consistently, we would have been taken out early on every single one of our favorite long-term winners.
Further, a stop loss of necessity takes one out of the stock at a low point rather than a high point. This does not mean, of course, that the stock will not go lower, but rather that you are being sold when the stock is down. And once a stop is triggered, it becomes a market order, meaning you may get sold at a price somewhat below your stop level, particularly in thinner markets.
The most fundamental objection to the continual use of stops, however, is this: if one is a long-term value investor and has done one's homework correctly, then when a stock price declines, it is precisely the time to buy more, not to sell. If one likes ABC at $60 and nothing has changed, one should love it at $40.
Having said all that, we use stops in two different circumstances. First, as discussed above under Shorts, we prefer to use stops when short selling. This is because stocks can move considerably above their true value for extended periods, and in short-selling, one must put up more margin when short sells move against you. As the old saying goes, "markets can remain irrational longer than most investors can remain solvent."
Secondly, we sometimes use stops when a stock has performed very well, and though we believe the stock is fundamentally overvalued, market conditions make us believe it could go even higher. So instead of selling, we will use a tight trailing stop, moving the stop up as the stock moves up. In such circumstances, a stop is to "protect profits" rather than to "stop losses".
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