What is a Protective Stop
A protective stop is a strategy designed to protect existing gains or thwart further losses by means of a stop-loss order or limit order. A protective stop is set to activate at a certain price level and assures that an investor will make a predetermined profit or lose a predetermined amount. For example, if one buys a stock for $50 and wishes to limit losses to 10%, one would simply set a protective stop at $45.
BREAKING DOWN Protective Stop
Although a protective stop is considered to be a risk-averse strategy, it can also be profit averse. Because it assumes that a stock will continue to fall past the exit target, a protective stop can sometimes backfire with volatile stocks that have a wide trading range. Hence, it is prudent to consider the behavior of the security when using or setting a protective stop. Because the "stop" acts as a floor, an investor who's security enjoys a subsequent rebound has guaranteed the investor to be "stopped out ."
A protective stop is a popular strategy for loss or risk-averse investors. Often, their tolerance for losses is acuter than other investor personalities. Popular tools for measuring risk include downside deviation and semivariance. Both measures are effective risk management techniques which can be added to a position and automatically triggered without a financial advisor's intervention. A common rule of thumb from behavioral finance says investors experience the pain of loss twice as much as the joys of gains. This phenomenon has come to be called prospect theory. As financial advisors increasingly add psychological factors to managing financial well-being, not just asset management, techniques like the protective stop will grow in popularity.