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Stop Losses – The Good, The Bad and the Ugly

Successful Completion of Rule of Three

In an earlier post, I mentioned that we were committing cash to the market because it had successfully completed one of my most reliable patters: The Rule of Three. You can read more about it here: Rule of Three

In the chart above, you can see the difference between the previous attempts to break through overhead resistance when they did not successfully complete the rule of three and the most recent one that did – the market has moved higher.

But in that moving higher process we have a number of holdings that are up more than 10% year-to-date. So that we protect those gains to the largest extent possible without prematurely selling a company that will move higher, we’ve added 2% trailing stop losses to each of those companies. What this means is that we are giving the company a 2% downward movement buffer before they are automatically sold. If the stock continues to move higher, then we will adjust the trailing stops so that they are reset to higher levels as well.

Here is a sampling of stocks that we are using this technique on. I’ve listed the name, the

    Year To Date

gain when the trailing stop was placed and the current status:

Agilent Technologies +15.32% :: Stock has moved even higher: +17.38%
Agrium +15.24% :: Stock has moved even higher: 16.79%
General Cable +15.76% :: Stock has moved even higher: +19.47%
Borg Warner +16.24% :: Stock has moved even higher: +17.54%
CF Industries +18.26% :: Stock has moved lower: +15.88%
Cummins, Inc +14.47% :: Stop Loss hit, sold for +12.45% gain
Eaton +13.43% :: Stock is slightly higher: +13.63%

This is a sampling of the holdings we have stops under, but what I wanted to talk mostly about is expectations for stop losses:

The Good: When it happens like Cummins, the stop acts exactly how you want it to. It moves down and on the first trade below your stop price, your shares are liquidated and you book the gain.

The Bad: Sometimes, like with Cummins, the stock’s move down is temporary and it is shortly thereafter higher. Cummins is up 2% since the stop loss hit.

The Ugly: Sometimes, you will have a news-related event that pushes the stock price down significantly and your trade is the first trade to hit. Look at the chart below of Annaly Capital:
Annaly Capital

If you had a stop loss set on Annaly and a news story hit that drove the price down significantly during the day, you would have been sold out significantly below where the stock closed that day. This is one of the things you risk when using stop losses, particularly with companies in a sector that is having so many issues as the financial sector.

There are a lot of misunderstandings about stop losses and they are not

    in practice

as good as they are in theory, but for the most part they work if you are careful in their usage and have realistic expectations.

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