Investing in Stocks and The Stop Loss

Stop Loss Safety Net

Stop Loss Safety NetI’ve promised some “Dry” articles for you, and not being one to forget about promises I?ve put this one together for the fans of my ?Dry? posts. This is the next post in my series on investing. It’s dedicated to the?“Stop Loss”. Personally, I think the stop loss is?one of the most?powerful, yet underused tools available to any investor, whether new or experienced. There’s a place for the stop loss in any investing or trading strategy.?Consider?it a safety net to help you with the risk management perspective of your investment strategy.I also think that with the current markets potential for a correction, the stop loss may be something that prudent investors should be considering. Many online brokerages, like Etrade, make it fairly simple to place these trades. If you’ve never heard of them before or need help placing the trade, make sure to call your online brokerage as they should be able to walk you through place a trade such as this.

?Why The Stop Loss?

For a long term investor, the stop loss can be an important risk management tool, a way to protect gains or minimize losses. I’ll get into sticky territory with this one since a long term investor should be willing to accept a temporary paper loss. But if part of your long term strategy is to minimize a loss at a certain pre-defined level, then the stop loss order is a good tool to help do that.

I use the trailing stop loss in my accounts that have a long term outlook. When a?position?hits a level that I’m comfortable with in terms of profit, I’ll usually put a trailing stop loss on it in the range of 5 to 15% percent as the trail. I’ll do that if I think there’s still upward potential for that issue and the percentage of trail will vary based on market conditions and the stocks beta (volatility) amongst other factors. If that position goes up, the trailing stop loss will follow it along. If it loses then it should (more on that later) sell out at the predetermined level you set for it.

One great use of the stop loss is when you know you’ll be away for an extended period of time without accessing or having access to your accounts. Should a serious market correction occur during that period, you may return to find that your 40 or 50% less well off then you were before you left. Can you imagine what you would have felt like if you had taken a vacation to a remote location in the late?September, early October?time frame?of 2008? The market opened at $11,139 on September 29, 2008 and closed at $ $8451 a week later on October 06, 2008. With stop losses in place, you would have mitigated your losses and had a cash position to start bottom fishing. Without a stop loss the situation would have been just plain ugly.

?The Stop Loss Explained

Before I go into too much detail I want ?to explain two different ways that you can place an order to buy or sell for a stock. When buying or selling a stock you can place a “limit order”?or a?“market order“. A limit order lets you specify at exactly what price you want that trade executed. A?market?order fills your order at the best available price but is a bit more volatile. My preference is to use market orders. I’ve been kept out of a good trade by using limit orders in the past whereas market orders get executed almost immediately and close to the last traded prices (although not always). It’s important to understand the difference between the two, when you place a stop loss order you can specify how you want it placed, as a market or a limit.

The basic?stop loss?is a fairly simple order. You can specify a specific dollar amount, or the “Stop Price” you want to sell at, if the price of that stock drops to the price you set, your sell order will be triggered. ?An alternative to the plain stop loss order is a?trailing stop loss?order. This type of order is a little more complex but it’s my preferred way of entering a stop loss order. The trailing stop will follow a stock up, either as a percent of the stock or as a dollar amount that you set when entering the order. So for example, if you have 100 shares of Gadgetron Inc, and it’s selling at $50.00 a share you might enter a trailing stop at 10%. When you enter the order, the stop price will be $45.00 Should Gadegetron go up to $60 a share, the stop price will follow but will now be $54 a share, 60-(60*.10). If you had originally?entered?the trailing stop loss as a dollar amount, lets say $5 in this case, your original stop price would have been the same, $45. But when the stock when up, your new stop price would have been $55, 60-5.

A trailing stop loss order requires a bit more information on your part. When entering an order for a trailing spot you’ll have three options on how you want the stop to be triggered. You will have to make a selection between ?Last,?Ask?or?Bid??to trigger the order. If it sounds complex,?don’t?fret, it’s not. The?Ask?option will trigger your order when the ask price of a stock matches your stop.?Similarly, the?Bid?option will trigger your order when a bid is place on a stock that matches your stop. Personally, I don’t like to use either of these since the stock?doesn’t?actually have to trade at your stop price to have your order entered. The “Last”?option is my preference when placing a trialing stop loss order. The stock has to actually trade at (or below) the stop price you set to?trigger?the order.

There is another option you’ll see when placing a stop loss order. The?“Stop Loss Limit”?order combines a stop loss order with a limit order. What that means is that once a stock drops low enough trip the stop order, a limit order goes into effect. This gives you a?significant?amount of control over what price your stop loss gets executed at, but it also carries the risk of your order not getting executed.?Personally, I’m not a big fan of limit orders and am especially wary of a limit order in?conjunction?with a stop loss.

?The Ugly Side of the Stop Loss

Stop Losses are not all flowers and sunshine. There’s a dark side to the stop loss and that is that there are risks in using these orders. One common school of thought is that?trading?floors can see your stop loss order. Stories abound of traders pushing a stock price down to trigger your order and then letting the market correct the price upwards. I’m not sure how true this is, especially as it applies to small quantities, but there are enough stories around to at least make you?believe?that the?possibility?exists.

Another?risk is that a stock that is getting sacrificed to the gods of fear may slide significantly below your stop and get executed at a very low price. Let’s go back to the fictional company I reference earlier, Gadetron Inc. You have 100 shares of Gadgetron and it’s been doing well and is currently at the $60.00 level. You decided that you wanted to protect your initial?investment?of $50 a share so you entered a trailing stop loss order at $10.00 below the “Last”. One bright day, there’s a news item that spreads throughout the Financial community like wildfire; Mr. Amfullabrains, the chief?scientist?and researcher of Gadgetron, has left the country and rumor has it that he has taken the all of the companies intellectual property with him. The price of the company?s stock takes a drastic plunge and you get stopped out. Not at the $50 a share you were looking for but at $35 a share. Is it possible? Yes it is, although the analogy is corny, the possibility exists. Just look at Enron’s price history and that will give you an idea of just how quickly a company?s stock price can plummet on bad news.

So is the stock loss order the right tool for you. It’s up to you to make that decision but it should be evaluated and considered as part of any investment strategy, especially when it comes to risk managment.

?Tell us about your experiences with stop losses.

Are there times when they’ve saved your?portfolio?

How about times that they’ve worked?against?you?

Related Articles:

What Do You Do When Things Go Wrong? ? 2 Guys and Your Money

How I Learned to Avoid Bone-Headed Financial Moves

?How To Begin Investing, Risk Management ?- I Heart Budgets

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  1. I think that using stop loss wisely is an important tool in an investors kit. You can’t keep track of your portfolio 24 hours per day. However, there are times when you don’t want to sell during a sell off and if you forget to turn it off you could automatically sell when you didn’t mean to.

    • John says:

      True, that’s one of the risks of using a stop loss. When I place a stop loss, I’m typically ready to sell anyway and am trying to squeeze a few more points out of the issue by using a trailing stop.

  2. Joe says:

    It’s not the right tool for me because I buy to own a stock, not to generate subsequent trades, taxable capital gains, etc. But great analysis of this tool. I’m pretty sure every stock I’ve ever bought has immediately taken a hair cut hahahah but I only really care about dividends and their sustainability.

    • John says:

      I don’t trade much anymore, I hold my stocks, win lose or draw for at least a year. When the time comes to sell though I’ll either sell immediately or if the stock is in an upward trend I’ll place a trailing stop on it. It seems to work. The stocks I have trailing stops on right now are in extremely profitable positions. If they sell off in a correction, I’ll look for entry points to get back in (if it makes sense, there’s got to be a significant spread in from I sold it to where it is at that to happen).

  3. Jim says:

    Great analysis Jose, wish I would have had a stop loss in place on a stock I own which recently filed for Chapter 11. I let greed get the best of me and took a lickin, I have since learned from that mistake. Great Post!!

    • John says:

      Jim, I have a number of horror stories where greed or emotion led to a nice fat loss on a stock. That’s why I wrote the “Don’t be an Emotional Investor” article as well as this one. I’m sure that anyone that has been in th emarket for a while has a number of pretty good (bad) stories!

  4. Thanks for the excellent explanation. I’m certainly no trader, but maybe if I get more brave in the future. Honestly, reading this makes me want to go buy more rental properties, but that is just an excuse not to understand more about something that seems complicated at first.

    • John says:

      Kim, I hope I didn’t leave the impression that I’m a trader! I used to trade on an intermediate basis but stopped, you had to put a lot of time into it to stay ahead of the game, almost as much time as blogging! I am a long term investor now, and that slow but steady approach has been the most rewarding. The “traders” i reference in this article are the folks that work for the large brokerage houses or the trading floors, they keep an inventory or a “book” of certain stocks and usually won’t hesitate to “fill their book” at a low price if the opportunity arises.

  5. Great post, Jose. I really appreciate this kind of info as we want to be prepared for our investing journey once we’re out of debt. Very informative and easy to understand for a newbie like me. I’ll be filing this one in my “favorites” file for future reference. 🙂

  6. “Personally, I think the stop loss is one of the most powerful, yet underused tools available to any investor, whether new or experienced.” I could not agree more Jose! In my work with retail investors over the years I was always amazed to see people not use these. I am not a trader by any stretch of the imagination and any that I do is in our IRA’s, but it’s a vital tool to help protect yourself on the downside.

    • John says:

      John, I’m not a trader in the retail or industry sense of the word but I do use the stop loss. I have a few set in place right now! Interestingly enough, most of my stock activity is in an IRA so that’s where the stops are usually placed! Thanks for stopping by.

  7. AverageJoe says:

    I remember telling people about the stop loss when I was an advisor. I loved it when people had never heard of it. “Really? We can set it up so it’ll automatically sell? Without us having to watch it?” It was like their birthday and favorite holiday all rolled into one…and because I brought it to them, they grinned at me like I’d invented it.

    Well, I really did….that and the internet.

    • John says:

      Lol, I hate it when I invent something and never make a dime off of it. Did you know I invented the remote controlled cable box in the early eighties? I really did and no one wanted it…..

  8. CF says:

    Very informative! I was first introduced to most of these terms when I worked for a company that developed forex software. I haven’t used any of these techniques myself in my investments – just don’t really feel comfortable with it yet.

    • John says:

      I think the reason many people don’t use techniques like these is a basic lack of understanding them and how they work. You should be comfortable with these techniques before using them.

  9. […] Investing in Stocks and The Stop Loss by Jose @ The Wise Dollar […]

  10. Chris says:

    Well, I tried a trailing stop loss order for the first time ever.
    It did work out how you mentioned: a few days after I initiated the trailing stop loss order, it tripped and the stock was sold (as it should have). within 2 days later, it had gone back over it. I locked in the increases as I wanted, and have since repurchased the shares that were sold in order to achieve the extra gains of the stock (they’re going ex-dividend either 3/17 or 3/18).
    Do you do your trailing stop loss orders on divvy type stocks, regular stocks, or both out of curiosity?

    • John says:

      Goods news! I’m glad that worked out well for you. I’ll use stop losses on both. I don’t do ex-div plays but will use a stock on a div stock if it’s got some serious gains that should be preserved.

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