Stop Losses Protect You From Your Own Assumptions

“No battle plan survives contact with the enemy”

Colin Powell

There are only a few “free lunches” on Wall Street and most of them are at dingy strip club buffets.  Of the handful of true, honest-to-god free lunches, diversification and the stop loss are the ones I emphasize most in my practice.

Today we’ll talk about stop losses and what they bring to the table in a tape like this one.

Essentially, the stop loss is here to keep your assumptions from losing you money.  We all make assumptions about events like the Fukushima plant meltdown but most of them are made in a vacuum of historical context.  We’ve already gone way past 1979’s Three Mile Island disaster (during which many traders were not even born) and are now approaching a potential Chernobyl scenario.  The trouble with the Chernobyl comparison, economically speaking, is that it occurred behind Russia’s communist Iron Curtain and not in the world’s third-largest economy like the disaster we face today.

Current estimates are for the death of 10,000 Japanese people and over $200 billion in costs.  Unfortunately, even these are just estimates.  Assumptions.

Traders and investors will be operating under all sorts of assumptions right now:

“This will bounce on the third day”

“The 200 day simple moving average will be key”

“The repatriation trade into Yen will further kill the dollar and treasury yields will shoot higher”

“The US Dollar will rally as THE safe haven for those looking to blow out of anything Asian”

“Japanese small caps will bounce the hardest if this thing blows over”

All of the internal and external managers that I use in my asset management business will have assumptions of their own.

I too have some assumptions.  Some will be right and some will be very wrong.  I accept this.  The great equalizer is the stop loss.  Already I’ve seen positions cut loose in the last few days.  Some of these positions I had assumed were already too oversold.  Turns out that in a global nuclear panic, nothing is “too oversold”.

Stop losses may take people out of their favorites, but they will allow them to buy those favorites back when the dust settles.  They will also allow those looking to the play the downside to gird themselves against an imminent reversal if and when the selling abruptly stops.

There will be a time when the making of assumptions is less dangerous and stops will bridge the gap from here to there.  So assume away, but be sure to allow for the possibility that your assumptions are either premature, myopic or even dead wrong.