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 a world of difference. Just about everybody can benefit from this tool in some way. Read on to find out why.
- Most investors can benefit from implementing a stop-loss order.
- A stop-loss is designed to limit an investor's loss on a security position that makes an unfavorable move.
- One key advantage of using a stop-loss order is you don't need to monitor your holdings daily.
- A disadvantage is that a short-term price fluctuation could activate the stop and trigger an unnecessary sale.
Stop Loss Order Strategy
What Is a Stop-Loss Order?
A stop-loss order 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. If the stock falls below $18, your shares will then be sold at the prevailing market price.
Stop-limit orders are similar to stop-loss orders, but as their name states, there is a limit on the price at which they will execute. There are then two prices specified in a stop-limit order: the stop price, which will convert the order to a sell order, and the limit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price or better
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, when giving the stock yet another chance may only cause losses to 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.
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.
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.
Not Just for Preventing Losses
Stop-loss orders are traditionally thought of as a way to prevent losses, thus its 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 the current market price, not the price at which you bought it. 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.
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). Because this is the worst price you would receive, 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 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.
Drawbacks of Stop-Losses
The advantage of a stop-loss order is you don't have to monitor how a stock is performing daily. This convenience is especially handy when you are on vacation or in a situation that prevents you from watching your stocks for an extended period.
The main disadvantage is that a short-term fluctuation in a stock's price could activate the stop 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 commission generated from the execution of your stop-loss order.
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.
Another thing to keep in mind is that, once you reach your stop price, your stop order becomes a market order and the price at which you sell may be much different from the stop price. This fact is especially true in a fast-moving market where stock prices can change rapidly. Another restriction with the stop-loss order is that many brokers do not allow you to place a stop order on certain securities like OTC Bulletin Board stocks or penny stocks.
Stop-limit orders have further potential risks. These orders can guarantee a price limit, but the trade may not be executed. This can harm investors during fast market if the stop order triggers but the limit order does not get filled before the market price blasts through the limit price. If bad news comes out about a company and the limit price is only $1 or $2 below the stop-loss price, then the investor must hold onto the stock for an indeterminate period before the share price rises again. Both types of orders can be entered as either day or good-until-canceled (GTC) orders.
The Bottom Line
A stop-loss order is a simple tool, yet many investors fail to use it effectively. 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.