While stop losses are typically only used when a trader is placing long-sourcing in-between positions, most professional traders are also using stop losses along the top of their trades in order to absorb losses when the stock rises. This allows them to be willing to take more risk – but is it a good idea?
In a 2007 paper, “Stick to Your Guns: A Review of the Economics of Stocks and Options in the Post-September 11 Era”, we argue that the “most important reason for using stop losses is the ability to absorb capital losses caused by price movements which are not fully controlled by one’s own trading strategy.”
Stop losses, it turns out, have been linked with lower profit margins and higher costs: “when a stock drops below a reasonable long-term target price, stop losses are the most appropriate tools for trading. This is true both for stocks with very large profit margins and for stocks with very small profit margins and price-to-earnings ratios. For stocks with relatively large profit margins and high profits and market capitalizations, as well as for stocks with small profit margins and low market capitalizations, stop losses may have only marginal effects.”
We think you deserve an honest appraisal if you’re considering using stop losses.
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Is it a wise strategy to buy and trade stocks based on the movements of certain indices?
It is, and you should be sure to follow it. The key to buying and trading stocks is to be careful not to trade based on “index-based” or “quoted-price” trends, especially during a sell-off. Stocks (and other financial assets) can rise or fall according to very small factors and can fluctuate by thousands of dollars in hours.
But even if your trading strategy is based on averages and averages are volatile, it would still make sense to be sure to follow a “buy and hold” strategy since you would only lose your money if the stock falls further than your buy-and-hold target.
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Ask The Expert Ask The Expert is a regular column where experts answer the pressing queries in the financial markets, from high-level research to life-changing advice