Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

How to Cancel Risk with Stop-Loss Orders

When the market keeps falling, the overwhelming desire for most investors is to stop the bleeding. The stop-loss order is only one way to put a tourniquet on your investments, but probably the most easy to use. Here's how you can incorporate this handy trick into your portfolio.

What Is a Stop-Loss Order?

A stop-loss (also called a stop order or stop market order) is an order placed with a broker whereby the broker automatically closes a trade on a particular stock if it reaches a predetermined price.

For example, let's assume that you own 100 shares of Company XYZ stock, for which you have paid $10 per share. Let's also assume that you are going to Bermuda for two weeks and will not be checking your portfolio during that time.

A lot can happen in two weeks, and if Company XYZ stock tanks during that time, you could lose a lot of money. One way to mitigate this risk is to set a stop-loss order at, say, $8, which means that your broker will sell the Company XYZ shares if the stock price drops to $8 while you're gone. That is, when the stop level is reached, your stop becomes a market order and the shares you hold are liquidated.

It is important to note that because the stop becomes a market order when the stock hits the stop-loss price, the investor also may be forced to exit the trade at a lower price (say, $6.50 in our example) rather than the price at which the stop was set ($8 in our example); this is often the case with thinly traded stocks.

Types of Stop-Loss Orders

Most brokers will allow two types of stops: "good until cancelled" (GTC) and "good for the day." (Please note that, in practice, many "good until cancelled" stops need to be reinstated at the beginning of each new trading month.) This of course will depend upon which broker you use. Some allow stop-losses only on certain stocks, and some allow them only for stocks traded on certain exchanges.

Setting the stop-loss price can be tricky. Put it too close to the entry price and the investor might exit the trade due to random market fluctuations. Place it too far away, however, and a small loss could turn into a painfully large one.

Academics and traders have several theories and approaches to setting stop prices, but one way to handle the situation is with a trailing stop. A trailing stop is a stop-loss order that is set at a percentage below the market price. For example, if you set a trailing stop on Company XYZ for 10% below the market price (the market price being $10), then when the stock goes up to $30, the trailing stop will trigger a sale only if the stock falls by 10% from $30. In other words, your stop-loss order is at $27 rather than the $8 in the first example. This helps investors lock in at least a portion of their gains during a rally.

Positives and Negatives

The primary advantage of stop-loss orders is that they help limit losses. However, investors should look beyond this when evaluating whether the strategy is right for them.

One thing to consider is that stop-loss orders are short-term trading strategy. They can take some of the day-to-day monitoring pressure off the investor, because they set the trade on autopilot to some degree. This is particularly helpful for emotional investors. But long-term, fundamentally oriented and buy-and-hold investors should probably be skeptical of stop-loss orders. After all, when a stock goes lower, it doesn't necessarily mean investors should sell -- especially those in for the long-term.

And even though stop-loss orders offer crucial trading discipline to investors by helping them make important decisions about cutting losses ahead of time (when they are more objective about the stock's real situation), they also run the risk of getting out of a position too early -- especially when volatile stocks are involved. In fact, if the fundamentals remain intact, a slight price decline might actually signal a buying opportunity that an investor using a stop-loss order would miss.

Because brokers rarely charge to place a stop-loss order, they're sort of like free insurance policies on an investment. That's good to have if you're a new investor.