I tend to get a lot of questions about the use of stop-loss orders – both in general and specific to my trading services, Cycle 9 Alert and 10X Profits. 

Anytime I’m asked, “Should I use stop-loss orders to protect my position?” my response goes something like this:

It’s up to you. But here’s what I’ll tell you… 

If you use a stop-loss order, you should put it far enough away from current prices, as to allow for the market’s “normal” day-to-day volatility. If it’s too “tight,” you get stopped out far too frequently… and you’ll never achieve the system’s total potential return. But, of course, if it’s too “loose,” it won’t really help you all that much at stopping losses. 

Realize there’s always a trade-off in using stop-losses. Sometimes it will help you… you’ll take a loss, but avoid a larger loss. Other times, though, it’ll work against you… it’ll stop you out at or near the worst of the drawdown, and then you’ll miss out on the recovery rally. 

The bottom-line is… if a stop-loss order helps you sleep better at night, do it. But, if you do it, choose a well-defined threshold and stick to it with discipline. Don’t adjust your stop up and down based on a whim or your gut feel. 

Now, I realize that answer has a bit of a “both-sides-of-the-mouth” quality.

That’s not because I’ve ever wanted to dodge this question. It’s merely because there isn’t a crystal-clear, always-true answer to it.

Like many things in investing, and life, the value of stop-losses lies in the grey area – of “yes and no… sometimes, maybe.”

Distinguished MIT professor Andrew Lo and his Ph.D. student, Kathryn Kaminski, tackled this very question in her 2013 thesis paper, titled, When Do Stop-Loss Rules Stop Losses?

Their conclusion was mixed.

Sometimes stop-losses provide a positive economic value, to some strategy types. Other times, stop-losses are a negative contributor, particularly for some strategy types.

If these guys couldn’t hone in on a clear answer, I’m not sure anyone will be able to.

We can focus on a specific market event, rather than trying to determine whether or not stop-losses are always beneficial.

How about the recent, early-February sell-off…?

I’ve done some analysis using the TradeStops stop-loss tools, which you may be familiar with if you’re a TradeStops member, or if you follow any of Charles Sizemore’s portfolios (he uses TradeStops).

Here’s a table of ETFs that track the four major U.S. stock market averages, and their leveraged, “2x” versions, along with their Volatility Quotient (VQ) and whether or not they were stopped out in early February.

Have a look…

First, notice the Volatility Quotients of these funds.

The “1x” stock funds average a VQ of 11%. This means you’d need to put a stop-loss order at least 11% below current prices to avoid constant whipsaws.

And, as we’d expect, the “2x” stock funds average a VQ that’s roughly twice as high, at 21.8%. This means you’d have to accept a bear-market drop (i.e. more than 20%) before allowing your stop-loss order to (potentially) stop the losses.

This balance between stop-losses that are too “tight” and too “loose” is tricky… and it’s the conundrum I was talking about in my answer above.

Next, let’s consider the interplay between each of the four major stock market indices and their respective, volatility-sized stop-losses in early-February.

The S&P 500 and the Dow Jones Industrial Average fell far enough to get stopped out. That was true for both the 1x and 2x versions, including SPY, SSO, DIA, and DDM.

On the other hand, the Nasdaq 100 and the Russell 2000 did not ever drop low enough to trigger their stops. Again, that was true for both the 1x and 2x versions, including QQQ, QLD, IWM, and UWM.

Now, since these markets have rebounded… you would have found yourself better off if:

  • You were in QQQ, QLD, IWM, or UWM.

Or…

  • You weren’t using stop-losses at all.

It won’t always work this way, of course. Had these markets not rebounded by now, we’d have reached a nearly-opposite conclusion. This is all because of the “yes, no… maybe, sometimes” nature of the value of stop-losses.

Of course, stop-losses do have their time and place. But when it comes to options… and other rather volatile vehicles, like leveraged “2x” stock ETFs, there are better ways to manage risk than with stop-losses.

Prudent position-sizing is one of them. And, related to the idea of not putting too many eggs in one basket, diversification is a great way to protect against outsized losses.

Consider the study above, where we saw two U.S. stock indices would have been stopped out in early-February (SPY and DIA, and their 2x funds)… while the other two were not stopped out (QQQ and IWM, and their 2x funds).

This shows clearly that, even though most stock indices move with a healthy degree of “togetherness,” they don’t make identical moves. Investors’ preference for different “flavors” of stocks – from large-cap to small-cap, and tech-heavy to industrial-heavy – can either work for you or against you… if you’re overly concentrated in one index or another.

Diversifying across a reasonable number of risk-on markets is a useful way to limit the risk of loss in any one market, should it be hit particularly hard by an unforeseeable event.

The bottom-line is… while stop-losses promise, via their very name, to give you want you want in times of trouble (you’re yelling: “STOP THE LOSSES!”)… in reality, they don’t always do so!

Tactics like prudent position-sizing and diversification are, in my eyes, better solutions for limiting losses.

Adam O’Dell

Editor, Cycle 9 Alert
Follow me on Twitter 
@InvestWithAdam

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Adam O'Dell
Adam O'Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with the minimum risk. Adam has worked as a Prop Trader for a spot Forex firm. While there, he learned the fundamentals of trading in the world’s largest market. He excelled at trading the volatile currency markets by seeking out low-risk entry points for trades with high profit potential. An MBA graduate and Affiliate Member of the Market Technicians Association, Adam is a lifelong student of the markets. He is editor of our hugely successful trading service, Cycle 9 Alert.