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…

[ad#Google Adsense 336×280-IA]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.

[ad#article-bottom]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…

  • Several brokers allow you to set up an e-mail notification (which is not a stop loss order) through their trading platform when a stock hits a certain price. You’re probably fine with this option, but I just don’t want my broker to know anything about my plans ahead of time.
  • Yahoo Finance gives you several ways to track the price of a stock. It’s simple to use and free, too.
  • TradeStops, which was created by an S&A reader, is much more flexible than Yahoo. Among other things, it allows you to set many different parameters for your stops, including volume, dates, and moving averages. It costs about $80 per year.

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

[ad#jack p.s.]

Source:  Daily Wealth