To Stop or Not To Stop

That's one heck of a question. Nothing seems more problematic in trading than the issue of stops, and how, when, or even if to use them. Some people, like Dr. Alexander Elder say to always use them. Others, like Jim Cramer say to never use them. I think the truth, as with most market matters, lies somewhere in between.

The whole point of a stop order is to keep from losing your shirt. Unfortunately, it doesn't always work that way. In your arsenal of trading weapons, the stop order is like a hand grenade. If not used carefully, it can kill you just as easily as the enemy.

First off, most stop discussions never say which type of stop they're talking about. There's two: the stop loss and the stop limit.

The stop loss order guarantees that it will get executed, but not at what price.

The stop limit only guarantees the price you'll get if you get executed. In a rapidly falling market, the order might not trigger and you might not get out at all.

It's taken me a long time thinking about it, but here's what I've decided about stops. In a normal market, trading a high liquidity security, a stop loss order can be an excellent way of enforcing trading discipline, guaranteeing your profit, and protecting you from, well, loss.

However, the problem with a stop loss comes when the market goes nuts and the VIX goes through the roof like last week. Imagine this scenario: you bought ACN back in March at 42. By last week, it hit 44, a full two points from your entry. So you feel pretty safe in placing a stop at your entry point. You're feeling good because you know the worst you can do on this trade is break even. Then last Thursday comes along and ACN drops to $0.01 in the blink of an eye.

Your stop triggers but ACN falls so fast who knows what price you get. If you're lucky, it will be 42. More likely, it will be at 30, 20, or maybe you're the one who sold for a penny. Then in another blink of an eye, it pops right back up again, only now it ends the day at 41. Your stop not only cost you your entire two point profit but now you're a whole point in the hole, and that's assuming the best case.

Sure, some of those ridiculous 1 cent trades got busted, but I'm sure a lot didn't too. And this isn't a rare occurrence. It happens all the time, just not quite so dramatically. Check out the action in DISH on 11/27/09 (and ask me how I know about that one). Believe me, there's no worse feeling in the world than seeing your tidy profit turn into an ugly loss because you thought you were being prudent.

So in a high volatility environment like we're seeing now, a stop loss order can be like throwing the pin and holding onto the hand grenade. This is where a stop limit order is much better. It will protect you in an orderly market and keep you from getting stabbed by these crazy deadly downward micro-spikes. There is absolutely no way to intelligently place a stop loss order in a market like this. Trader emptor!