Stop loss orders seem like a good idea. Who wouldn’t want to lock in a profit, or, at least reduce a loss? Having an automatic sell order at a certain price trigger should guarantee a successful trade. That’s the theory anyway.

The reality is, however, quite different. Brandon Osten, the founder and chief executive of Venator Capital Management, in his monthly hedge fund commentary recently outlined five reasons why stop loss orders don’t work so well. They are well worth examining.

1. Losses may actually be higher

You might put in a stop loss trade to avoid a loss. But what if a company has such bad news that investors all want out at the same time?

Let’s say your stop loss is in the books for 10% lower than where the stock was trading at the time of the news. But if the stock opens down 25% after the news, your stop loss (and those by others) simply causes more market selling.

You might be happy accepting a 10% loss, but you might actually end up with a 35% loss. Not much protection offered there.

2. No crash protection

In the flash crash of May 6, 2010, the market dropped 6% in a matter of minutes, only to stage a subsequent and giant recovery before the close. A true stop loss would likely have triggered some fairly devastating sell orders into an illiquid market, and your portfolio might have dropped well more than 10%.

That day, some large-cap stocks famously traded at 1¢ per share, because there were simply no bids to match market sell orders (these were later reversed, but trades within 60% of the pre-crash price were not reversed). Automatic orders are just not good in a crash scenario.

3. Lack of follow-up options

If you get stopped out, do you get to buy another stock or do you  just stay in cash forever? Can you ever buy back the stock you sold? Can you only buy it at a lower price? What if you sell an oil stock on a stop loss only to turn around and buy another oil stock? Are you really any better off?

If after executing a stop loss you immediately buy something else, your risk hasn’t really been reduced.

4. What is a loss anyway?

At what point is a stop loss triggered? Is it 10% from your cost base? Is it a loss from the stock’s highest point since you bought it? What if it is held in two different accounts with different purchase prices?

If you consider a stock broken and uninvestable when it falls 10%, then it shouldn’t matter when you bought the stock, and you should use 10% from the all-time high as your trigger point.

5. The value investor’s dilemma

Based on the above, Mr. Osten summarizes you can’t be a value or contrarian investor and still believe in stop loss orders.

If you have to sell (and therefore can’t buy) any stock that is 10% below its all-time high, then you’re only purchasing stocks near their all-time highs. This means you — by definition — are not a value or contrarian investor, as value stocks are unlikely to be trading near their highs.

In summary, stop loss orders can simply handcuff you. If your favourite stock is declining, you need to do some research to find out if there is a reason for the drop.

Maybe there is a reason, and maybe you should sell. But to automatically sell simply because the stock is down devalues the research you have already done and your intelligence.  If you liked a stock at $10, you should love it at $8.

Getting stopped out turns you into a black-box investor, not a fundamental one.

Peter Hodson, CFA