Is it Possible to Invest Safely Without Stop-loss Orders?

We are told by the pros that stop-loss orders are the means to shelter profits. Yes, placing stop-loss orders right after you have opened a new position is good advice. However, stop-loss orders are not a solution. They are about as practical as swatting flies with a sledge hammer.

Here is a list of some of the problems with stop-loss orders:

"I had a 10% stop loss, but it closed out with a 20% loss"

"If I use a 10% trailing stop, I'll get stopped out too soon; if I use 20% I'll give up too much profit"

"The market moved so fast, the stop-loss order got filled at the bottom"

Let's analyze the last problem situation listed above, because it happens so frequently. In a fast price move, it is doubtless that you will sell out of your position at the bottom of the full move. For example, sometimes the market moves very fast causing price hits at a large number of stop-loss levels. People tend to set their stops at roughly at the same levels. (Yes, they do know where your stop is set and yes they do gun for these stop-loss levels.)

When all these stop-loss market orders are triggered, there are virtually no buyers or very few buyers at that price. The market systems are overwhelmed and by the time your order gets filled, the price has moved close to the bottom of the move. After being filled, generally the big buyers come in and move the price back up. If you have been investing for a while, you have run into this. You probably got trapped on May 6 when the DOW fell 1000 points in 30 minutes.


Why do the professionals with large holdings do this? They drive the market down so that the stop-loss orders are triggered. The market tanks because there are all those sell at market orders. When the price appears to be at the bottom, they buy back in. This is how they can conduct the market. They buy large blocks of stock at a bargain prices. This is called "running the stops".

You are in good company
I belong to a large investment club. Scores of the members are struggling with stop-loss. Almost all members moan and groan whenever the matter turns to stops. They know about the stock market threats such as: Desert Storm, Bosnia, 9/11, "Too Big to Fail". Experienced traders know that setting a stop-loss order won't help much in these instances.

Great Stocks?
Most have bought great stocks only to see their value fade away: Enron, Citibank, General Motors, General Electric, Cisco, AIG, Lehman Brothers, Filene's Basement, SGI, Bennigan's Restaurants, Six Flags. The list of so-called "great stocks" that fell is almost endless.

Why They Fall
The grounds why equities drop in price are equally endless:

"A reasonable forecast was met, but the stock price crashed"

"The SEC is investigating the CFO"

"Consumer confidence is down"

"It paid a nice dividend, but the price fell even more"

"Record earnings and the stock still fell"

"Running the stops"

How to stop playing their game
There is an enormous difference between trading stocks and trading broad-based indexes. Without any doubt, it is possible to make much more money with stocks; but, you can also lose more. Trading broad based indexes such as SPX, leveraged ETFs and other baskets of stocks provides less spectacular returns. The advantage, however, is that problems with individual stocks in the index have a diluted effect on the price of the index. You won't have to fear most of the common reasons why prices fall precipitously.

When it comes to investing, hitting singles is easier than hitting home runs - and they can end up being more profitable. Consider trading the following broad-based indexes.

The S&P 500 is an index, obviously of 500 stocks; the Russell 2000 traces 2000 stocks. If one or more of the equities in the index experiences a large reduction in price, it would scarcely make a swell in the price of the index. I'm not indicating the price of an index will not fall if there is bad news. But, trading these indexes is the key step toward minimizing risk.

Trade with the trend
The next step requires recognizing market direction so that you can trade in the same direction as the market is trending. You don't want go long in a Bear market. Similarly, you don't want to go short in a Bull market. This applies to both stocks and indexes. There are other times when the direction is indecisive. During these times, you don't want to bet on a direction; you should be safely in cash.

Unbiased View
A market timer is essential because it provides an unbiased view of the market direction rather than the hype provided on many news channels and newsletters.

Most market timers are based only on the chart of the index they are following. They must be optimized periodically to accommodate market changes. These timers generally forecast either Bull or Bear markets.

An excellent market timer, in contrast, integrates market sentiment with the chart and produces one of three forecasts, Bull, Bear or Neutral. For example, from September 2007 through January 2010, the SPXTimer reported Neutral over 25% of the trading days.

I decided to test the SPXTimer by trading the Proshares Ultra ETFs for the S&P 500: SSO for Bull markets and SDS for Bear markets. By the way, the SDS is an inverse fund; it goes up when the S&P 500 goes down. It allows investors with IRA accounts to trade in Bear markets. There is no shorting allowed in an IRA account, but you are allowed to use the SDS to earn returns during these down periods instead of shorting.

No Need for Stops
Both SSO and SDS are leveraged 2:1. If there were a need for stops, this test would be the proof. The test ran from September 2007 through January 2010 - the time period when SSO and SDS were available. You might know that these Ultra ETFs were introduced in late 2006. There were almost 79% winning trades with an Annual Rate of Return [ARR] over 34%. Next, I ran similar tests of the Nasdaq 100, Mid Cap 400, and Russell 2000. The largest losing trade for any of them was 21.64%. Each had over 70% winning trades and even higher ARRs.

I decided to push the stress test even further by using the Direxion 3:1 ETFs on the Russell 2000, TNA and TZA. Because these are newly introduced ETFs, the testing could only be run from 2/20/2009 - 2/11/2010. There were 87.50% winning trades with an ARR over 60%. The largest losing trade was under 16%.

Summary
By using a market timer, you can eliminate your need to use stop-loss orders on your trades. The SPXTimer is unique because it not only shows bull and bear directions, but it indicates when it is appropriate to be in cash, protected safely on the sidelines.