Understanding Stop Orders: Part 2
In our previous article we discussed the four basic types of stop orders:
- Stop Loss
- Stop Limit
- Trailing Stop Loss
- Trailing Stop Limit
In addition to these order types, there are many other “logical stop orders” that you can implement as part of your trading strategy, such as exiting if the stock price falls below its 200-day moving average. Depending on the sophistication of your trading platform, you may be able to enter logical stops as conditional orders, or you may just have to track the price of the stock and enter an order manually at the appropriate time.
The real question is whether to use stop orders or not.
Stop orders are a form of insurance: they are designed to limit your losses when the stock price moves against you. And, like all types of insurance, there is a cost to using stops. Our research has consistently shown that using stop orders helps smooth out the volatility of your returns and reduces drawdowns, but also decreases the total rate of return of a strategy. The reason for this is that no matter how sophisticated your method is for selecting your stop loss price, there will be times that the stop order gets you out of the trade too early and you miss out on potential gains.
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Of course, all this assumes that you’re starting with a well-defined, quantified strategy that’s consistently executed. If your “strategy” is to buy stocks that a friend tells you about over lunch, or ones that are mentioned on CNBC, then stop orders may be an excellent way of avoiding major disasters.
As with many aspects of trading, the decision regarding stops comes down to personal preference. If having stop orders in place lets you sleep better at night, then use them. Likewise if you’re managing someone else’s money and that person is sensitive to fluctuations in his or her account value. But if obtaining maximum returns over the long haul is your primary goal, then you might want to seriously consider passing on the stop orders.
As you might guess, our own approach to making this decision is to let the data guide us. When we back test our strategies, we typically compare the historical results of variations that use stops with those that don’t. That provides a much clearer picture of how much benefit the stops are providing, as well as their cost in terms of foregone profits.