How Useful Are Stops in Today’s “Algos Gone Wild” World

I have friends who gave up on the stock market after the flash crash event on May 6th, 2010. They were like: “I had my money in trends I understood and stocks that I liked, I had my stops in place just like I was taught and bam, on May 6th I was stopped out of all my positions at prices below my stops. I am not going back, ever” (I know, using market stop loss order is not bright)

And I understand them completely.

We have all heard it a thousand times:
– The basic premise of consistently profitable market engagement is cutting your losses short and letting your winners run;
– If you can’t take a small loss, sooner or later you will take the mother of all losses;
– As a position moves in our favor, we are supposed to move our stops to protect some of the profits;
– Discipline should always trump conviction;
– Never say never and Never fall in love in anything that can’t love you back…

Sounds reasonable, sounds wise, but when algos go wild, it might turn against you.

I saw a lot of frustrated people on the StockTwits’ streams today due to the multiple mini flash crashes and decided to follow up with a few suggestions how to deal with this issue:

1) Most long-term trend followers use closing prices for their entries and exit signals. In the words of a legendary trend follower Ed Seykota: “Having a quote machine is like having a slot machine at your desk – you end up feeding it all day long. I get my price data after the close each day.” Occasionally staying away from your screen has its benefits… If you are an intraday trader, days like today are called an opportunity.

2) Limit your market exposure during noisy market periods. Safety is derived from the timing of your market engagement and position sizing. Proper timing doesn’t consider only the technical characteristics of the setup, but also the overall market environment at the time. Market is healthy two to three times a year and this is when the majority of money is made. Trading during the rest of the time will only frustrate you. For example, I made the bulk of my profits in the first 4 months of the year. After that, I have little to show. A lot of chop, a lot of efforts and basically a little better than breakeven since May.

3) Use option spreads to limit your risk. Of course this is applicable only to liquid stocks.