I was asked recently what’s the point of using stop losses “since the stock is always going to go back up?” This person’s argument against stop losses was 1) they make an unrealized loss become a realized loss and 2) you will then miss out on the ensuing up move that is guaranteed to happen (I may have dramatized their explanation just a bit). While such certainty may seem appealing to a novice trader, any experienced trader knows nothing could be further from the truth. While we know empirically that the broader market has an upward bias over long periods of time (think decades), this does not imply that there is some invisible force precluding your stock from going down. Likewise, there’s no magical guarantee that your stock will go up. But it just has to! Pull up a chart of CLF or WLT or RSH (you’ll probably get an error on that last one, as they’re going through bankruptcy).

On a slightly more serious note, it’s normal to want to give current positions more room. It’s human nature. We are programmed to want to book open profits too soon and hold losing positions too long. In other words, it’s human nature to have small gains and large losses. But does this sound like a sustainable strategy? You don’t need to be a math major at an Ivy League school to know that the math just doesn’t work; you will end up blowing up your account sooner than later with such a tilted strategy. While some people may be able to get away with this, especially in a market like we’ve been in the past couple of years, these hopeful traders will get crushed eventually and will give back those lucky profits sooner or later. The next RSH is always right around the corner (I don’t mean to pick on RadioShack, it just illustrates the importance planning for the worst).

Why let one position make or break you? Why let one trade dictate your success or mood? Develop a plan that you’re comfortable with and stick to it. If a stock hits your stop, get out, plain and simple. This doesn’t mean you have to be a hyper-active trader risking only 20 cents or panic out every time the market takes a dip. If you have a longer time frame, you can give yourself some room to work with. The key is to develop a situation where you know your original trading thesis is no longer valid, and so you hit out of your position and move on to the next trade. This doesn’t even necessarily have to be a technical stop. If you’re strictly a fundamental trader/investor, you’re “stop” could be a fundamentally based stop, e.g., slowing earnings or sales growth, decreasing margins, lost market share, etc. (I would still advocate following basic price action and using technical stops accordingly).

The morale of the story is develop a trading plan, be disciplined with your stops, only risk what you’re willing to lose, and don’t fall prey to the alluring guarantee of forever-appreciating stocks. Know where and when you’re wrong. Don’t be like Day Trader Dave and lose all your wife’s money. 



Let me know if you have any questions or comments.


Don’t Be Like Day Trader Dave: Use Stop Losses!
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