In the past we’ve discussed developing a strategy as an investor and then sticking to those rules and goals you’ve developed. One tool in building a trading and an investment strategy is the stop-loss order. Placing a stop-loss order on a stock or fund (ETF or ETN) can help you implement safe guards that will protect your portfolio against losses beyond your predetermined threshold.
In a sense investing in stocks is a gamble, but that does not mean you must subject yourself to the threat of losing your entire investment when you buy a stock. Stop-loss orders are a trading mechanism that enables investors to place a pre-set floor on any stock price movement. Think of a stop-loss order as a type of limit order. You are limiting your risk of a loss by placing a rule with your broker to sell if X stock falls below a set value.
(Please note that a stop-loss order executes when a set price is hit. Therefore, your sell order happens when your predetermined price is reached. The next trade could be higher or lower, which means that you are guaranteed to sell at the exact price of you set for your stop-loss order.)
There are two clear advantages in my mind for investors who use stop-loss orders. First, it enables you to develop a strategy that is buffered from the emotions that can run wild when the market is going north, south or sideways. You have a game plan and the stop-loss order makes it so that you stick to the game plan.
Secondly, some investors cannot or do not wish to monitor their stocks on a frequent basis. For this type of investor, the stop-loss order works as a monitoring system. If any sort of unexpected negative news about a company emerges that makes the stock take a sudden turn for the worst, you do not have to worry about ridding the stock’s downward momentum to the point where the stock finally finds it feet. In sort, you can sleep easy at night knowing you have a line of defense to prevent your portfolio from going into a free-fall.
Though I believe stop-loss orders are a great tool for most investors, you must put some serious thought into the dollar value they are placed at on a per stock basis. The orders should also be re-adjusted as a stock increases in value. For instance, if you purchase a stock that is very volatile (has a high Beta), you must recognize that the stop-loss order should probably not be very close to the stock’s purchase price. If this strategy is taken, the stock by its volatile nature will most likely trigger the stop-loss order because the stock moves around a lot in dollar or percentage terms. When you set a stop-loss order you are trying to protect yourself from a situation when a significant price drop starts to occur. You do not want to cause the order to engage because of normal fluctuations.
If you are a rather risk-adverse investor, stop-loss orders might be just what the doctor ordered to help you become a more engaged stock investor. If you do not watch your portfolio that closely or have multiple stock positions, stop-loss orders can protect you against unforeseen negative news that seeks to throw your company’s stock price down a few rungs. No matter what your situation might be, stop-loss orders are a simple yet powerful tool to help your stick to your investing strategy and protect your portfolio against significant losses.