My Two Cents - "Fred Carach - The case against stop-loss orders"

08/06/2008

Nothing is more devastating to today's investors than being "stopped out" of their stocks. Or as I fondly call it, being blown out of your position. When I broke into the stock market more than 40 years ago only professionals used "stop loss orders". Today it appears almost everyone uses it. And in my estimation most investors would be far better off if they had never heard of a stop loss order.

A stop loss order is an automatic order to sell your stock if it falls to your pre-set authorized selling price. Upon learning about stop loss orders, Joe Investor is wildly enthusiastic. It sounds like the greatest thing since sliced bread. Joe investor will almost always set his stop loss at one of three price points. At either 5% below his entry point or at 7.5% or at 10%. Joe is convinced that he is now running with the big boys and doing the smart, sophisticated thing. Not exactly. Quite the contrary. Joe has now put himself into the clutches of the "smart money boys", who are going to introduce Joe to whipsaw city. Whipsaw city has many skyscrapers and the smart money is going to throw Joe and his compadres off of every one of them. The falls are brutal. In the end Joe will drag his broken, mangled body out of whipsaw city and never be heard from again. He will have been broken by stop loss order hell.

What does the smart money know? It knows that there is a range of between 5%-10% below every stock that is a mass of stop loss time bombs waiting to go off. The only thing they need to do to ignite this mass of stop loss time bombs is to simply drive the stock down 15%-20% and they will all be ignited. They are the stock market's "weak sisters". Buyers whose only conviction is that all falling stocks are going to zero and must therefore be sold at once. This is why if you stick around for very long you will notice that stocks rarely fall 5%-10%. They almost always fall 15%-20% to insure that they have blown all the weak sisters out of their position. Having blown the weak sisters out of their position, the smart money is now ready for part two of operation whipsaw. The comeback. The smart money knows that the stock is now in the "strong hands" of the conviction investor. The conviction investor is the investor who actually knows why he owns the stock. Isn't that a refreshing change. The smart money knows better than to tangle with these hard cases. And why bother. They know that a strong floor now exists in the stock. The existence of a strong floor means it is now safe to buy the stock The smart money now begins to buy the stock with a vengeance. Three months later the stock is selling at 30% higher than Joe's purchase price. Joe should have a 30% profit on his stock. Instead he has a loss of say 10%-15%.

Welcome to whipsaw city Joe. There is only one way out. You must become a conviction investor. I will show you how. One final word of warning is required. This strategy only works with value plays. It doesn't work with momentum or growth plays. The boys have a real scorn for these type of investments. And why not? The only conviction these investors have is that you should buy a stock if it is going up and sell a stock if it is going down. When you stop to think about it that is not too impressive is it? The boys ask themselves why should we take the stock down only 15%-20%. When we know we can take it down 50% or 80%. After all these clowns are not just clueless but are living in total darkness.