What with so many facets to look at and brood over when weighing a stock buy, it's easy to forget about the little things. The stop-loss order is one of those little things, but it can also make the world of difference. Just about everybody can benefit from this tool in some way. Read on to find out why.
What Is a Stop-loss Order?
It is an order placed with a broker to buy or sell once the stock reaches a certain price. A stop-loss is designed to limit an investor's loss on a security position. Setting a stop-loss order for 10% below the price at which you bought the stock will limit your loss to 10%. For example, let's say you just purchased Microsoft (Nasdaq:MSFT) at $20 per share. Right after buying the stock you enter a stop-loss order for $18. This means that if the stock falls below $18, your shares will then be sold at the prevailing market price. (For further reading, see A Look At Exit Strategies.)
Positives and Negatives
The advantage of a stop order is you don't have to monitor on a daily basis how a stock is performing. This is especially handy when you are on vacation or in a situation that prevents you from watching your stocks for an extended period of time.
The disadvantage is that the stop price could be activated by a short-term fluctuation in a stock's price. The key is picking a stop-loss percentage that allows a stock to fluctuate day to day while preventing as much downside risk as possible. Setting a 5% stop loss on a stock that has a history of fluctuating 10% or more in a week is not the best strategy. You'll most likely just lose money on the commissions generated from the execution of your stop-loss orders.
There are no hard and fast rules for the level at which stops should be placed. This totally depends on your individual investing style: an active trader might use 5% while a long-term investor might choose 15% or more. (For further reading, see Limiting Losses.)
Another thing to keep in mind is that once your stop price is reached, your stop order becomes a market order and the price at which you sell may be much different from the stop price. This is especially true in a fast-moving market where stock prices can change rapidly.
Not Just for Preventing Losses
Stop-loss orders are traditionally thought of as a way to prevent losses thus it's namesake. Another use of this tool, though, is to lock in profits, in which case it is sometimes referred to as a "trailing stop". Here, the stop-loss order is set at a percentage level below, not the price at which you bought it, but the current market price. The price of the stop loss adjusts as the stock price fluctuates. Remember, if a stock goes up, what you have is an unrealized gain, which means you don't have the cash in hand until you sell. Using a trailing stop allows you to let profits run while at the same time guaranteeing at least some realized capital gain. (For further reading, see Trailing-Stop Techniques.)
Continuing with our Microsoft example from above, say you set a trailing stop order for 10% below the current price, and the stock skyrockets to $30 within a month. Your trailing-stop order would then lock in at $27 per share ($30 - (10% x $30) = $27). This is the worst price you would receive, so even if the stock takes an unexpected dip, you won't be in the red. Of course, keep in mind the stop-loss order is still a market order - it's simply stays dormant and is activated only when the trigger price is reached -- so the price your sale actually trades at may be slightly different than the specified trigger price.
Advantages of the Stop-Loss Order
First of all, the beauty of the stop-loss order is that it costs nothing to implement. Your regular commission is charged only once the stop-loss price has been reached and the stock must be sold. You can think of it as a free insurance policy.
Most importantly, a stop loss allows decision making to be free from any emotional influences. People tend to fall in love with stocks, believing that if they give a stock another chance, it will come around. This causes procrastination and delay, giving the stock yet another chance. In the meantime, the losses mount....
No matter what type of investor you are, you should know why you own a stock. A value investor's criteria will be different from that of a growth investor, which will be different still from an active trader. Any one strategy may work, but only if you stick to the strategy. This also means that if you are a hardcore buy-and-hold investor, your stop-loss orders are next to useless. (Read more about these different approaches in the Guide to Stock-Picking Strategies.)
The point here is to be confident in your strategy and carry through with your plan. Stop-loss orders can help you stay on track without clouding your judgment with emotion. (See The Importance of a Profit/Loss Plan.)
Finally, it's important to realize that stop-loss orders do not guarantee you'll make money in the stock market; you still have to make intelligent investment decisions. If you don't, you'll lose just as much money as you would without a stop loss, only at a much slower rate.
A stop-loss order is a simple tool, yet so many investors fail to use it. Whether to prevent excessive losses or to lock in profits, nearly all investing styles can benefit from this trade. Think of a stop loss as an insurance policy: you hope you never have to use it, but it's good to know you have the protection should you need it.