While we usually talk about the benefits of using stop losses for your investments, last week’s trading was a nasty wake up call that introduced many investors to the bad side of stop losses. Here’s everything you need to know about the dangers of stop losses – and everything you need to know to profit in spite of them.

Using the “what goes up must come down” gravity theory, the risks of a sell off increased greatly with the April rally. The $VIX fear gauge showed complacency was at its highest point (the VIX was at its lowest point) since the Lehman Brothers collapse that started the current financial crisis. Hindsight makes it clear that a pull back was due eventually but fighting the trend and guessing the market top is never a prudent solution.

The combination of news events increased investor anxiety enough to do something. Thursday’s sell-off was the result. And although the market has since re-stabilized, the intraday trading that went on taught some valuable lessons.

Standing stop loss protection orders are one market tool that is often more art than statistical science. An exit strategy is absolutely necessary to control risk – but the devil is in the details. A stop too close may get knocked out in normal fluctuations while a stop too far away doesn’t provide solid financial protection on a move against you.

Typically traders will keep moving the stop exit orders up when their positions are moving favorable to lock in gains. With the recent stock market run and a yearlong rally an abundance of sell orders laid below. The conditions were set for a snowball to roll down the hill gaining speed from standing orders on the books to SELL.

The proliferation of high frequency and program trading has taken over the markets accounting for more than 60% of volume each day. Those technology and speed advantages are designed to profit from the tiniest inefficiencies to arbitrage between markets or exchanges. They also kick in when buying or selling trends develop to jump on to ride the wave – trades like that can happen in minutes.

That’s part of the reason that I don’t provide rigid stop losses in for my Resource Trader Alert readers.  I keep an eye on the price action of all of our positions and when the time comes to take action rest assure that I’ll issue an Urgent Trading Alert.  Clearly it’s better to keep an active eye on the market instead of a standard stop/profit targets – and our track record can vouch for that.

Where to Go from There

But if the stocks that have stop loss protection aren’t even safe, where should investors turn? The panic and volatility should be a reassurance that when all heck breaks loose, as it does from time to time, commodities are a great place to weather the storm

With paper currency and stock certificates on the decline, gold is a natural alternative. Trying not to sound like the barrage of commercials for coins on TV, it’s safe to say that hard assets hold value in uncertain times. As such, gold rose last week and is set to make new all time highs.

The flight to safety rally into Bonds and the US Dollar last Thursday should be watched for signs of stability. The move back down to the technical breakout point from Wednesday can indicate the end of equity and corresponding overall asset decline. Bonds below 120 and the Dollar at 83 are key levels to follow.

Sincerely,
Alan Knuckman
Penny Sleuth

May 12, 2010

Alan Knuckman

Alan Knuckman brings two decades of commodity trading experience to his role as managing editor of Resource Trader Alert, a weekly newsletter providing analysis and real-time updates on current and evolving market conditions. His options, futures, and currencies experience have made him a sought after commentator on issues shaping both hard (extracted or mined) and soft (grown or produced through the agriculture industry) commodities. He is a frequent guest on major international media outlets including CNBC, Sky News, MarketWatch, Bloomberg, Fox Business Network, CNN Money, and Reuters.

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