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A Hidden Danger Facing Newsletter ReadersBy
Wednesday, July 13, 2011
Longtime DailyWealth readers know the key to successful trading and investing is an intelligent exit strategy.
Statistics show even the best traders are right on only 55%-60% of their trades. Given these odds, the key to making plenty of money as an investor is to get the most out of the picks you get right... and dump your misfires when the losses are small.
One of our favorite tools for managing winners and losers is the stop loss. The basic idea of a stop is to set a downward limit for your investment. Simply put, a stop loss is a predetermined price at which you will sell a stock, regardless of anything else happening with the company or in the market.
You can find a more detailed discussion of how stops work here. But today, I'd like to show you a hidden danger facing newsletter readers who use stop losses...
When readers get started with the stop loss idea, often the first thing they do is set their stops with their brokers. It makes sense... You don't want to sit by your computer all day watching share prices, so you tell your broker at what level you want to sell. If your stock hits that level, your broker sells automatically. Simple, right?
Here's the problem: Entering your stop with your broker allows other traders to see where your stop is set.
If lots of investors have stops set at about the same price – which happens with recommendations from popular newsletters – and the stock is fairly "illiquid," professional, high-volume traders (called "market makers") can actually move the share price down to trigger those stops.
Once the selling is done, the price will quickly rebound... But you're left with a loss.
Your broker might scoff at this. One reader forwarded a response from her broker that said:
The person that wrote this is either an idiot or it was written 20 years ago. The markets are all electronic now. All stop orders are either held on exchange servers or on the brokerage servers but no traders have access anymore. Completely disregard. It's not relevant.
It is true the current system has fewer early "looks" at orders than the older system of the so-called "specialists" – real people who held real orders in their hands and saw all the stops ahead of time. But there are still people behind the scenes who ensure a liquid market. The current system is a mix of electronics and real people who still have a "high-touch" approach for "discovering and improving prices, dampening volatility, adding liquidity, and enhancing value."
In other words, there's more than enough potential for "cheating," especially if you make it easy for them.
I've seen it happen to colleagues' subscribers more than once... A microcap biotech stock dropped 10% one day for no reason, "picked off" readers who had entered their stops with their brokers, and bounced right back up to close about even. A mortgage REIT we recommended opened down 14%, just below the stop... stayed there for 10 or 15 minutes... and ended up closing higher than it did the day before.
The lesson here is NOT that you shouldn't use stop losses. They're one of the easiest, most powerful tools investors have at their disposal. The lesson is that you can't show your hand at the poker table and still expect to win.
Remember, these market makers have capital at risk. They want to make money off you and me on every single trade. It's naïve to trust that your broker or Wall Street won't take every advantage you give them.
If you're the sort of person who leaves a 16-year-old home alone with the keys to your convertible Ferrari and believes he won't drive it while you're away on your African safari... then by all means... put your orders in with your broker.
If you're not, you have a few choices for how to track your stops...
If you get an alert that you've hit a stop, stick to your selling discipline and close out your position the next day. This is one of the hardest things to do. But I promise if you do it right, it will save you thousands of dollars and untold grief.
Here's to our health, wealth, and a great retirement,
Doc Eifrig
Further Reading:
Find a couple of the best investment tips we've ever shared here:
"If you really want to be certain you're not going to lose money," Dan Ferris writes, "you shouldn't invest in stocks with money you're going to need in less than 10 years."
Steve Sjuggerud shares a table every investor needs to see. "Let's say your investment loses 10% or 20%... or even 90%," Steve writes. "In the right column is how much your investment has to rise to get back to where it started..."
Market NotesAN UPDATE ON THE BIG "ASIA UP, THE WEST NOT SO MUCH" TREND On Monday, European stock markets plummeted. Italy, the new poster child of the euro crisis, saw its benchmark stock index fall to its lowest level in two years.
It's the latest price confirmation of a giant trend you'll rarely hear about: "Asia up, the West not so much."
The long-term case for owning Asian assets versus U.S. and Western European assets is simple... Over the past 40 years, the Western world has cooked up a stew of unfunded welfare programs, huge government debts, and populations who've adopted a "something for nothing" way of life. Asia, on the other hand, isn't burdened with the "welfare state of mind." Most Asians are poor... but they're working and saving like crazy to catch up with the rich Westerners they see on TV and YouTube.
This situation makes it attractive to "buy Asia, sell Europe." And you can track how that trade is doing with a ratio chart plotting the performance of the Singapore fund versus the performance of the Italy fund. A rising trendline shows Asian stocks outperforming European stocks. As you can see, the latest round of euro crisis just sent this ratio skyrocketing to a new high. It will continue to go higher.
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