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Using a Trailing Stop Loss to Reduce Risk

A reader writes in, asking:

“What are your thoughts on implementing a Stop Loss/Trailing Stop Loss for your positions? More specifically, does a trailing stop loss make sense given the added protection against downside risk? I thought it might be an interesting question given the current stock market valuation.”

How Does a Stop Loss Work?

For those who are unfamiliar, a stop loss order is an order that says, “if the price of this holding falls below $x, sell my shares.” A trailing stop loss is an order that says, “if the price of this holding falls by a certain dollar amount (or percentage) from its highest point since I placed this order, sell my shares.”

Example: Bob holds shares of an ETF that is currently worth $90, and he sets a trailing stop loss to sell if the price falls by 10%. That would currently mean that if the share price falls to $81, his shares will be sold. However, if the share price moves upward, the trigger price for his order will move upward as well. For example, if the share price climbs to $100, the new trigger price would be $90 (i.e., a 10% fall from the new high).

Does a Stop Loss Reduce Risk?

To answer the reader’s question, yes, a trailing stop loss is an effective way to provide some “added protection against downside risk.” It isn’t perfect protection, because the price at which the sell order is actually filled could ultimately be lower than the trigger price if the price is falling very quickly. Still, it does reduce risk relative to simply holding something without a stop order.

But, to state the obvious, the fact that something reduces risk doesn’t necessarily make it a good idea. Selling all of your existing holdings and moving everything into a short-term TIPS fund would also reduce risk, but it wouldn’t make sense for most people.

Is a Stop Loss a Good Idea?

Many people first learn about stop orders (trailing or otherwise) and think it’s a simple way to “miss” downward movement. For example: “I’ll set a trailing stop order to sell when the price falls by 10% and then I’ll buy again after it has fallen by 15%. That way I’ll get to miss out on part of the fall while still being able to experience the eventual rebound.”

The problem with this line of thinking is that it neglects to consider what happens if the stock falls 10%, but then rebounds before having fallen by 15%. In such a case, the person has sold their holding but does not buy back in at any point. At some point, they will have to decide whether they want to go ahead and buy back in anyway at a higher price than the price at which they sold.

Moving these two price points closer together (rather than 10% and 15%) does reduce the likelihood of such a scenario, but it also reduces the “payoff” when the strategy works out. That is, it reduces the amount of price decline that the investor gets to avoid.

In addition, on each roundtrip (i.e., selling the holding then eventually buying it again) there are transaction costs that must be overcome in order for the strategy to provide a net gain.

To state the issue another way: A stop loss order essentially says that you don’t want to sell at today’s price. But you would be willing to sell at a price lower than today’s price. For example, I don’t want to sell it today for $100, even though I could. But I would be willing to sell it in the future if the price falls to $90.

This is a line of thinking that does not, in itself, make sense. It only makes sense if you think that prices are predictable. That is, it only makes sense if you think that the lower price tomorrow means that it’s about to go down further rather than going back up. Unfortunately, short-term stock movements are not usually predictable. (This is why strategies that use price movements to predict future price movements are not generally successful.)

In summary, yes, trailing stop orders do reduce risk. But my personal view is that I don’t think most people should bother with them. Most people, if they desire to reduce the risk in their portfolio, are going to be better served by doing it in a simpler manner: by adjusting their asset allocation.

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