Locogmac's recent post and the ensuing discussion got me thinking about stop losses.  I have a few short comments and an example from my own crappy trading.  Long story short, I think stop losses are one of the most useful tools a speculator can have... and even investors may find them useful.

• First off, stop losses act to protect you from yourself by automating the process of disposing of a losing position.  This is very important.  There's a lot of research in behavioral economics that shows that people in general absolutely hate taking losses.  If it's a paper loss, the thinking goes, that's okay, but a realized loss?  No one likes taking them unless it's the end of the year and you have offsetting income to shield from taxes.  What the stop loss does is it spares you from having to make the agonizing choice to finally take the loss: the computer will do it for you.
• Second, the stop loss gives you visible confirmation that you screwed up when you initially put on the position.  If you bought a stock at $20, thinking it would go up to $28, and instead it goes down to $15, you screwed up in either your timing or your reasoning.  And if you were wrong, why do you still hold the stock?  If you put in a stop at $16 you would've saved yourself 5% as well as avoided the temptation to just "let it ride" and get married to a losing trade.
• Lastly, stop losses (barring gaps up or down) prevent a position from running away from you.  We can't be glued to our screens for every waking hour, and it's useful to have the computer to trim your losses while you're busy at work if things get out of hand.

An example, one from my own collection of mistakes.  Yesterday I sold short 75 shares of Fannie Mae (FMN) at $24.73.  The reasoning isn't important (though I could get into it some other time).  I also put in a stop at $26.10, a little more than five percent above the share's price.  That was at roughly 10:00.  An hour later, with the market continuing to rocket into the stratosphere, my stop was taken out at $26.13, for a loss of $105.  My prediction that FNM would fall was obviously wrong.  And it continued to be wrong; the stock closed at $28.22 that day, and gapped up at the open today at $29.60 before finishing at $30.71.  My stop saved me over $340.

And the beauty of it was that I didn't have to think about it... I didn't have to get angry at myself for screwing up... the computer took me out automatically and that was that.  As I said at the time, Thank God for Stop Losses!

Now, it obviously doesn't work for everything.  For something less liquid than large cap common shares, like options, you don't want to put in a stop because a wild swing that doesn't necessarily reflect the conditions in the underlying might take you out.  But for common stock that you don't plan to hold on to for a couple of years?  The stop loss is your friend.

Good post! Looking back on my comments, I guess I gave the impression that I am totally against stop losses and that people who use stop losses are bad investors. I hoped I sort of cleared that up later on in my comments, but just to make it clear again...

I think stop losses do their job well for day traders and speculators, as you say. I am more a buy and hold type of investor. I do have some weeks where shares come in and go within the week, and also a few times within the same day. But, for my main holdings, I've never used stop losses. Part of that is because I these are buy and hold holdings, and another is because more than  75% of my portfolio is in solar stocks. Yes, I am overweight on solar probably, and I should probably diversify a little, but we'll leave that topic for another day. Anyways, the volatility of solar stocks is tremendous, and had I been using stop losses along the way, I'd have no positions right now basically. I'm glad to say that my main solar holding (JASO) is about to go under the Long Term column within a week or so, and that any realized gain on that will be tax free (Thanks again to Bush's Tax Cuts). 

Very good post. Both of you missed a crucial point of stop losses though: they can be used to protect profits (a lesson learned myself). Stop losses (or trailing stops) can be adjusted as needed to lock in profits, something that is crucial to being a successful trader/investor. A lesson learned when I bought QID a few weeks ago, and had it rise nicely on me, but my strategy had a flawed plan (I was going to hold the stock and sell at end of day Friday) but, I ended up riding it all the way down and when I sold manually on Friday, I took a loss. Had I used a stop loss and at least set it at my break-even point, I would I could have avoided a lot of pain.

One thing that I've read on a lot of different sites is "the difference between amateur traders and professionals (or profitable traders) is they don't let winning trades turn into losing trades." They always set a stop at their break-even point, if not higher.

Good point, Fuzzy.  I love the trailing stop as well, and should've mentioned that in my post as a means of protecting your winners.  Again, part of the beauty of it is that it's all automatic, meaning that there's no chance you'll be able to talk yourself into doing something you know you shouldn't do.  And if you're like me, that happens quite often.  After all, we're only human.