Until you sell your stock, you do not make money, be it at a profit or loss. That makes selling one of the most important things for any investor, yet it is also one the hardest thing to do. Factors like ego, insufficient knowledge and emotional attachment makes it difficult for investors to sell, specially at the right time. But even bigger factor why investors do not sell at the right time is due to lack of exit strategy. Many investors enter a trade without any idea of what their exit strategy is. They more likely take premature profits or worse, let their losses run to the downside, at times completely burning their portfolio. To be successful investor, one must understand what exits are available to them and know how to create an exit strategy that will help minimize losses and lock in profits. One such strategy is the stop-loss order.
What Is a Stop-loss Order?
Stop-loss order is simply an order placed with a broker to sell off the stock at a set price level. A stop-loss is designed to limit an investor’s loss on a stock. Generally stop-loss orders are placed at prices that give an indication that an exit is the best move to make at that time. What price level to set the stop-loss order would depend on the type of investor (ie. value investor, growth investor or day trader
Stop-loss Order Example
Let us go through a quick example to understand it better. Say Mr X purchased stocks of Danger Inc. at $100 per share. Mr X put a stop-loss order of 10% below the buying price (ie. $90 per share). If the stock price of Danger Inc. falls below $90, the stop-loss order Mr X placed will be executed and the stocks will be sold off. Is it foolish to sell off below the purchase price and take a loss ? Yes and no. If the price of Danger Inc. would have fallen to $80, Mr X would have accumulated a bigger loss. Setting a stop-loss order for 10% below the buying price will limit the loss to 10%. In this case, Mr X decided to minimize his loss and move on to a profitable investment.
Advantages of Stop-loss Order
Minimize Loss: Provides a safety net and helps limit the loss only to a certain level rather than taking a big hit.
Less Monitoring: Don’t have to monitor on a daily basis how a stock is performing. This is especially handy when on vacation or away for an extended period of time.
Free of Cost: It costs nothing to implement. Regular commission is charged only once the stop-loss price has been reached and the stock must be sold.
No Emotional Influence: Allows decision making to be free from any emotional influences. Many investors tend to fall in love with stocks, believing that if they give a stock another chance, it will come around. This could lead to more losses.
Disadvantage of Stop-loss Order
Short-term Fluctuation: 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.
Need to Know Fluctuation History: 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. Without knowledge on the fluctuation history, investors will get burned using the stop-loss order.
Different Sell Price & Stop Price: Once the stop price is reached, the stop order becomes a market order and the selling price may be much different from the stop price due to fast-moving market where stock prices change rapidly.
Few Restrictions: Many brokers do not allow you to place a stop order on certain securities like penny stocks.
Not Just for Preventing Losses
Stop-loss orders are traditionally thought of as a way to prevent losses. It can also be used to lock in profits. Investors can set the stop limit (also called trailing stop
) at level below the current market price instead of the buying price. This way if the stock goes up, an extra profit is made. If the stock goes down, the locked profits are still there for taking. In short a trailing stop allows to let profits run while at the same time guaranteeing at least some realized capital gain.
Let us go back to the above example to show how trailing stop works. Mr X purchased stocks of Danger Inc. at $100 per share. Say within a month the stock price jumped to $120 per share. Now at this point Mr X is not sure about the direction of the stock price. He decides to use trailing stop order for 10% below the current price, which would be $108 per share. This is the worst price he would receive, so even if the stock takes an unexpected dip, he won’t be in the red. This way he has protected his investment and locked in some profits.
Conclusion: A stop-loss order is such a simple little 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. Investors should think of it as a insurance policy which they hope not to use it, but its good to have that protection. It is important to realize that stop-loss orders do not guarantee that investors will make money in the stock market. Investors do have to do thorough research before using stop-loss orders.
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