Why I will NOT use stops…and you shouldn’t either!

Stop orders trigger automatically when the price of the stock hits a certain level. Many times they are presented as ways to “set your max loss” or “stick to a system.” I say nonsense. Stops are bad ideas. Investors should NOT be using them. Here’s why:

Your stop price is painfully obvious to all of us–Everyone knows round numbers and almost everyone knows support/resistance basics. Putting your stop just on the other side of those levels is the obvious move. I know for a fact that when a stock moves from $10.05 to $9.99, tons of market orders are going to come flying in because of stops. If I’m short, I will be trying to push the stock to $9.99 to watch the mass exodus. If I’m looking to go long, I won’t buy until the panic is on and I can get in cheap. Your stop is forcing you to do the same thing as the crowd, at the same time. NOT how you make money.

The odds of HITTING your stop are MUCH higher than the odds of the stock staying below it–For this one, I’m turning to thinkorswim. If you aren’t on TOS yet, get on it. You’ll learn more the first month than you already know, and you’ll challenge yourself into a whole new way of looking at the markets. Anyway, here is what I see in there:

This is a breakdown on AAPL looking at the JUNE options chain (today’s price is $181.61). Using some advanced math, the TOS system is showing me that the probablity of AAPL closing below 175.00 on June 20th is only 33.67%. On the other hand, the probability that AAPL will TOUCH 175.00 between now and then, and thus trigger my stop order for a loss, is 65.93%! In other words, if I go long AAPL here at $181.61 and set a stop at $175, I have a 2/3 chance of losing money on the trade even though there is only a 1/3 chance that the stock will be below $175 in eleven days. Yikes.

Slippage > Commissions– The best example I’ve heard on this came from Tom Sosnoff. He says “Let’s say you buy a stock at $100. You set a limit sell at $101 and a stop at $99. I can pretty much guarantee you that if your limit hits, you’ll fill at $101.00. On the other hand, if your stop hits, you’ll probably fill at $98.60-$98.95.” In other words, you’re giving up $.05/share or more in slippage when you use a stop. If your broker charged you a nickel per share to make a trade you’d probably raise hell….so why do it to yourself?  Set an alert to be notified when your stock is nearing your stop and use a limit order to get out appropriately. You’ll save tons in slippage over the years.

You can accomplish the intent with options (EVERY TIME!)– Limiting risk is certainly a great intention. Unfortunately, stops don’t really do that for you. The stock could gap down $20 tomorrow and blow right through your stop, turning your “max 9% loss” into a 35% loss easily.  On the other hand, through options spreads, you can DEFINE your risk completely. No slippage, gaps don’t matter, and most importantly….you can profit even when the stock moves against you (or not at all)….and you can still profit when AAPL touches $175.00 but then moves back above it!!!

I’m not going to get into the details of options spreads in this post…consider this a preview of what is to come. I just want to get your mind thinking beyond the basics that everyone uses and into the more powerful strategies that you should give yourself access to.

Thanks to Kevin Frey for his post about stops that got me thinking in this direction. Even though he calls stops “necessary”, his post does make for some pretty good examples of exactly what I’m talking about.