Friday, September 25, 2009

Stopping In The Name Of Losses!

Stop-loss orders are often recommended to investors of all types, especially those who aren't always watching the market. For value investors, however, the benefits of stop-loss orders are not as high as they are for other market players, yet value investors still fully suffer from the drawbacks of stop-loss orders. The question therefore becomes: should value investors use stop-loss orders?

On the one hand, stop-loss orders can still serve a purpose. For example, if bad news for a company gets released at 10:06 am, and the stock goes into free-fall, a stop-loss could get an investor, still unaware of the news, out of the company at 10:09 am.

On the other hand, value investors tend to understand what they are buying (lowering the risk of an unexpected impairment), prefer companies with low debt to capital levels (lowering the risk that a company can't unexpectedly make a payment), and prefer to take advantage of volatility (rather than fall victim to momentum trading). As such, they are less likely to benefit from the protections offered by a stop-loss.

On the other hand, value investors are still prone to the negative effects of stop losses: when the market panics unjustifiably, stop loss orders kick in and investors are exited from their positions at prices far inferior to what they may have been willing to sell for!

Consider what happened one year ago to the parent company of United Airlines (NASDAQ: UAUA). Panic swept the market after a false rumour of bankruptcy spread throughout, causing the stock to drop 99.92% (from $12 to one penny!). Following news that the rumour was false, the stock returned near its original level. Those with stop-losses got exited at terrible prices, as the stock dropped like a rock. Even if an investor had a stop loss at $10, it would have been filled at a much lower price, since there were no buyers at $10 during this panic.

While we've previously discussed the idea that airlines do not make for very good value investments, the example depicted above can happen to any company when a market panic occurs, even if there has been no change in a company's fundamentals.

Before deciding whether or not to use stop-losses, value investors should ensure they understand both the (possibly reduced) benefits as well as the drawbacks.

1 comment:

burack said...

A good compromise is a stop-limit order. This can prevent you from selling a firesale prices, but still allow you to exit if the stock declines at a normal, non-whiplash pace.

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