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How a Stop-Loss Order Can Make You a Sitting Duck for Other's Profit

 

 

Q:  Should I Add a Stop-Loss Order to the ETFs in my Portfolio to Protect Against Loss?

A:  The short answer is 'No' – one reason being that our strategies make all trades at mid-day on Mondays – after the weekend update of each model. The longer answer is that we NEVER use (and highly discourage the use by subscribers of) Stop-Loss Orders, which are executed the moment your ETF drops a single penny below the percentage or price you set as its Stop. This article will provide you with several good reasons to NOT apply a Stop Loss Order to the ETF-based positions in your systematic investment model, and show you how market makers and other insiders regularly turn everyday investors into sitting ducks – which those insiders take advantage of to generate easy profits.

Take a moment and think about what a Stop-Loss Order really is: an arbitrary percentage below which you are going to sell a position – based solely on your perceived fear threshold, assessed at that particular moment in time. This definition also applies to entry-based stops, because they are just a percentage you arbitrarily set below the price at which you bought the position – a level where you think you will start feeling uncomfortable.

Tomorrow or next week your percentage pain threshold may be far different than it is today when you enter the order. And it's certainly not very systematic. Our extensive testing of Stop-Loss Orders demonstrates that they are neither prudent nor effective. This article will tell you why Stop-Loss Orders are a terrible idea, and we hope that after reading this article, you will vow to never use another one for the rest of your investing life!

 

The Problem with Intraday Prices

We have run thousands of backtests on trailing and entry-based Stop-Loss Orders, and they invariably result in less profit and frequently higher drawdowns than if the investor uses their strategy's rules as designed. While it may seem counterintuitive that a stop loss would cost you money, it is a logical result of equity prices being very *noisy.*

Prices being noisy means there is a lot of mostly inconsequential ups and downs during every market session as investors test the high and low thresholds of market prices – levels that may only be important to a select (but often material, volume-wise) group of short-term traders. Instead, our strategies always base decisions on the weekly closing prices on Friday, which have far less noise and, for our purposes, are the only prices that matter.

An investor could argue that if the bottom drops out of an ETF in the middle of the week, a stop loss will prevent losses in that event. However, 99% of the time that's just not true. One reason is that the "bottom doesn't drop out" of an ETF as can occur in individual stocks from bad news. 

Dozens, hundreds, or even thousands of different companies comprise ETFs, and it's highly unlikely that they're all going to collapse at the same time. If there is something like another "Flash Crash,' the best policy is to ignore it.  We certainly hope you don't lose an enormous amount of money – as many thousands of investors did – because you have a Stop LosStop-Loss Order ETFs (which is exactly what happened in the 2015 Flash Crash). If positions drop by -40%, as occurred in the '2015 ETF Flash Crash,' by all means – do the opposite of sell!  If you have any cash on the sidelines and your strategy is saying you should remain invested, then you should put that money to work and Buy, Buy, Buy at an enormous discount!

 

Stop-Loss Orders tend to do the opposite of what you want; they can LOCK IN LOSSES – rather than prevent them – by selling your position on a brief and temporarily tick lower.

 

Even after the fast-paced, 1987 selloff of -25% (the majority of which occurred in a single day), stocks were much higher by a couple of months later and went on to climb higher for the next 13 years; until the dot-com bubble burst in 2000.  A savvy investor will have stayed fully invested if that's what his or her quantitative strategy was recommending in 1987.

 

Manipulated Prices and 'Sitting Ducks'


It's a sad but true fact that some unscrupulous market makers will temporarily extend prices downward if a typical stock-loss threshold is just a bit lower than the current price of an ETF or stock. For example, let's say that an equity has slumped for the last few days and is currently selling for $63.50, with its 50-day moving average not far below, at $59.69. The position represents an industry that is on stable ground from the perspective of expected profits, it's in a long-term uptrend, and there are no immediate, fundamental problems in the foreseeable future.

However, opportunistic market makers might subtly manipulate the price of that stock or ETF down to $59.68, then buy a huge position as tens of thousands of Stop-Loss Orders are triggered and with quiet glee as the equity quickly recovers – logging a 6% gain in a matter of moments. The market maker's boss and investors are happy, but you no longer own the position and have a loss on that trade because you had a stop loss just below the 50-day moving average. Set your stop loss at the 100-day or 200-day moving averages and they will get you there too!

Don't believe it happens? Please go check out the price chart of nearly any stock or ETF when they are hovering near a significant moving average. They will frequently drop just below that moving average, and moments later are back above it while hundreds or thousands of investors quickly lost a bundle because they had on a stop loss. It's a typical way that insiders take advantage of ordinary investors.

Chart 1 below shows an example using the S&P 500 index at the 50-day simple moving average (SMA) and 50-day exponential moving average (EMA). The exponential moving average (EMA) more heavily weights recent prices, allowing it to react quicker to price movements. Both the EMA and SMA are about equally popular, depending on the need. These two 50-day moving averages are a common threshold where insiders often take advantage of amateur's Stop-Loss Orders because they know that many will place a stop loss just below that level. Also, the 50-day moving average is not so bearish that the insider risks the ETF or stock going into a deep selloff to lower levels (such as can occur at the 200-day or 250-day moving average), and is not so tight that it's difficult to predict when there will be a quick cross (such as the 10 or 20-day moving average).

However, these cherry-picked, Stop-Loss based trades occur at virtually every moving average you might imagine, across thousands of stocks and ETFs, and on every timeframe that is used regularly by traders; daily, weekly, hourly, 15-minute, five-minute, you name it – there are moving averages that traders utilize and which are routinely used by less experienced investors as rule-of-thumb, stop-loss levels.

 

Stop-Loss Orders at major moving averages offer a profitable set-up for insiders
Chart 1: Stop-Loss Orders at moving average levels used by a significant volume of investors are regularly harvested for millions of dollars in profits by insiders.



The market-maker, block trader, market insider – or these days, often a well-designed, high-frequency trading (HFT) program – will make relatively small purchases to inch the position's price down to just below the 50-day SMA or 50-day EMA (both are popular) or other significant moving average using different time frames, causing many thousands of Stop-Loss Orders to trigger depending on the popularity of the stock or ETF. The insider or HFT program then reverses its approach and scoops up these forced, automated trades with a massive amount of open buy-limit orders, reaping risk-free profits as the position returns to more normal trading levels in the following hours and days.

In Chart 1 above, you can see that there are a dozen times on this daily chart during 2017 that the S&P 500 was pushed to just pennies below its 50-day SMA or 50-day EMA. Then, when those orders were filled as the market maker scooped up the automated stop-loss trades, the index rapidly climbed higher and big profits were scored. The larger the market capitalization, the harder a trade is to manipulate, but look at all the potential daily trades at the 50-day moving average in 2017 on the S&P 500 – representing the largest, blue-chip stocks in the US. Thousands of equities and ETFs every single day are hovering near their significant moving averages – perfectly set up for this scam.

Rinse and repeat – across dozens of different moving averages, time frames, and thousands of stocks and ETFs crossing moving averages every single day – and you have a money machine that consistently takes advantage of unwary, amateur investors. The insiders win, and inexperienced investors lose their investment dollars, yet again. Add up dozens or hundreds of trades like this every day, and you can have a comfortable, multi-million-dollar annual business for yourself based on taking advantage of amateur's Stop-Loss Orders. But then, you will still have to come up with a good story to tell St. Peter at the pearly gates, to explain why you spent your life as such a depraved miscreant.

 

Use a Well-Designed, Quantitative Investment Strategy Instead


Instead of using the a Stop-Loss Order – which at best is very blunt and ineffective tool, and might even make you a sitting duck for the profit of others – to try to protect yourself from significant loss, it is far more prudent to put your investment choices in the hands of a carefully crafted, emotionless, quantitative decision system that is constructed well in advance of market turbulence – rather than selling at a price only selected because that's all the temporary downturn you felt you could emotionally handle at the time you enter the order. Granted, a Stop-Loss Order may be better than panic selling, but probably not by much...

Instead of an emotional approach to selling, considered using a systematic strategy, which we construct using a composite of as many as three-dozen different indicators from a wide spread of disciplines, instantly analyzing and interpreting the components of macroeconomics, stock fundamentals, internal market breadth, and technical signals of both the equity and fixed income markets. 

It is impossible for a blunt percentage or a sell rule based on an ETF's entry price to match the benefits of extensively-considered rules based on solidly grounded investment principles – confirmed by extensive backtesting and live, out-of sample performance – developed into sophisticated algorithms in an ETFOptimize quantitative strategy. Adding a Stop-Loss Order to your positions, when triggered will negate all the systematic considerations of these carefully constructed quantitative strategies.

So, our recommendation is never to use a trailing or entry-based Stop-Loss Order. Also, we suggest you try to avoid monitoring market events and investment-related news – which is inherently designed to elicit an emotional response from its viewers. Like traffic slowing on the freeway with passengers craning their necks to see the results of an accident, television channels such as CNBC gained an 800% increase in viewership during the 2007-2008 Financial Crisis, as a result of the constant airing of threats of imminent danger espoused by seemingly every guest.

Why not allow the ETFOptimize strategies to do all the market monitoring and make all the stressful decisions, while you check your model on Sunday evening or Monday morning to get performance updates and see if there are any changes (you should fill recommended ETF trades at mid-day on Monday).

Otherwise, you should sit back and relax – with a patient, long-term perspective, knowing that you have the best investment approach that's available – constructed by a design team that has more than 50 years of collective investment and strategy-design experience. Instead, enjoy all the wonders and exciting challenges that your life has to offer, and don't waste another precious minute on the TV talking heads or monitoring market charts.

 



 



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