Protecting Your Investments: The Power Of Stop Losses

Stop-loss orders are a crucial part of any investor's exit plan. They are designed to limit an investor's loss on a security position that makes an unfavourable move. A stop-loss order is a risk-management tool that automatically sells a security once it reaches a certain price, either a percentage or a dollar amount below the current market price. It is designed to limit losses in case the security's price drops below that price level. However, there are disadvantages to using stop-loss orders. In this article, we will explore the pros and cons of using stop-loss orders and provide guidance on how to determine the best price for a stop-loss order.

Advantages of stop-loss orders

Stop-loss orders are an important risk-management tool for investors. They are designed to limit potential losses by triggering the sale of a stock once it reaches a certain price. Here are some advantages of using stop-loss orders:

• No cost to implement: Stop-loss orders are typically free to set up, and investors are only charged a regular commission once the stop-loss price has been reached and the stock is sold. This makes it a cost-effective way to protect your investments.
• Hands-off approach: One of the key benefits of stop-loss orders is that they allow investors to take a hands-off approach. You don't need to monitor your holdings or the stock market daily, as the sale will be triggered automatically when the stock reaches the specified price. This is especially useful when you are on vacation or unable to watch your stocks for an extended period.
• Emotion-free decision-making: Stop-loss orders help remove emotions from investment decisions. Investing can be an emotional endeavour, but setting a stop-loss is a logical, disciplined strategy that can prevent investors from holding onto losing stocks due to emotional influences.
• Lock in profits: While traditionally used to prevent losses, stop-loss orders can also be used to lock in profits. For example, investors can use a "trailing stop" to designate a certain percentage or amount below the current price, ensuring that their gains are protected even if the stock price drops.
• Part of a disciplined strategy: Routine use of stop-loss orders encourages investors to be more disciplined in their investment strategies. By setting pre-determined exit points, investors can avoid the temptation to hold onto losing stocks or make impulsive decisions based on short-term market fluctuations.

Disadvantages of stop-loss orders

Stop-loss orders are a great way to manage risk when investing, but they do come with some disadvantages. Here are some of the key drawbacks to be aware of:

• Price gaps and market volatility: Stop-loss orders are vulnerable to price gaps, which can occur between trading sessions or during trading halts. If the stock price suddenly drops or rises above the stop price, the order will be triggered, and the stock will be sold or bought at the next available price, even if it's sharply away from your intended level. This can result in unnecessary sales or purchases.
• Fast-moving markets: In a fast-moving market, the execution price may differ significantly from the stop price due to rapid price fluctuations. This is especially true if the market is experiencing high trading volumes.
• Partial fills: A stop-loss order may only be partially filled, resulting in multiple commissions and reduced overall returns for the trader.
• No guarantee of execution: A stop-loss order does not guarantee that a trade will be executed. The price may never reach the specified limit, or there may be other orders in the queue that utilise all available stocks at the current price.
• Not suitable for long-term investors: Long-term investors are generally less concerned with short-term market fluctuations and are more focused on the long-term performance of their investments. Stop-loss orders may result in unnecessary sales due to temporary price drops that would have little impact on long-term gains.
• Not always available: Stop-loss orders may not be available for certain stocks, and some brokers do not allow this type of order for specific securities.
• No guaranteed profits: While stop-loss orders can help limit losses, they do not guarantee profits. The actual execution price may differ from the intended price, resulting in potential losses.

When not to use a stop-loss order

Stop-loss orders are a great way to limit an investor's loss on a security position that makes an unfavourable move. However, there are certain scenarios where a stop-loss order may not be the best strategy.

Firstly, if you are a long-term investor, you may not need to use stop-loss orders as you are likely not concerned with short-term market fluctuations and can afford to wait for the market to recover from downturns. In this case, a stop-loss order could result in unnecessary sales. Instead, long-term investors should focus on their investment strategy and make adjustments as needed based on market trends.

Secondly, in a fast-moving or volatile market, a stop-loss order may not be effective as the price at which you sell may be significantly different from the stop price. This is because, once the stop price is reached, a stop order becomes a market order, and in a rapidly changing market, stock prices can fluctuate widely. As a result, you may end up selling at a much lower price than intended.

Thirdly, if the stock you are investing in has a history of significant price fluctuations, a stop-loss order may not be the best strategy. For example, setting a 5% stop-loss order on a stock that regularly fluctuates by 10% or more in a week could result in frequent unnecessary sales. In this case, you may want to consider a higher stop-loss percentage or an alternative risk management strategy.

Lastly, if you are unable to place a stop order on certain securities, such as OTC Bulletin Board stocks or penny stocks, a stop-loss order may not be an option. In these cases, you will need to explore other ways to manage your investment risk.

It is important to note that there is no one-size-fits-all approach to investing, and the decision to use a stop-loss order will depend on your individual investment style, risk tolerance, and investment goals.

How to place a stop-loss order

A stop-loss order is a risk-management tool that automatically sells a security once it reaches a certain price. It is designed to limit losses in case the security's price drops below that level.

Here's how to place a stop-loss order:

Define Your Stop-Loss Strategy

Stop-loss levels shouldn't be placed at random. The ideal place for a stop-loss allows for some fluctuation but gets you out of your position if the price turns against you. One simple method for placing a stop-loss order when buying is to put it below a "swing low". A swing low occurs when the price falls and then bounces back up, indicating that the price found support at that level.

Determine the Price Level for a Stop-Loss Order

The best price for a stop-loss order depends on a few factors, including your risk tolerance, the volatility of the security, and your investment goals. Technical analysis tools such as support and resistance levels can help identify a good price for a stop-loss order.

Place the Order

Placing a stop-loss order is similar to placing any other type of order. You'll start by selecting "buy" or "sell". Your order ticket may default to a "market" order type, so you'll need to change that to "stop". Then, pick your stop price and place the order.

Monitor and Adjust the Order

Once a trade is showing a moderate profit, you can adjust the stop-loss order to protect part of your profit. This can be done manually or by using a trailing stop that automatically advances the stop-loss order to a higher level as the market price rises.

Be Mindful of the Risks

While a stop-loss order can be a useful tool, it does have some potential drawbacks. A short-term fluctuation in a stock's price could activate the stop price and trigger an unnecessary sale. Additionally, once a stop price is reached, a stop order becomes a market order, and the price at which you sell may be much different from the stop price.

Stop-loss orders vs. stop-limit orders

Stop-loss orders and stop-limit orders are tools that traders and investors can use to limit potential losses. While both types of orders are used to mitigate risk, there are some key differences between them.

A stop-loss order triggers a market order when a designated price is hit. In other words, it will be executed at the best available price in the market when the stop price is reached. This means that a stop-loss order guarantees execution but does not guarantee the price. The actual execution price may be lower than the stop-loss price, especially for securities with high volatility.

A stop-limit order, on the other hand, triggers a limit order when a designated price is hit. This means that it will only be executed at the specified limit price or better. A stop-limit order guarantees the price but may not be executed if the limit price is not met.

Both types of orders can be used by investors who are long or short, depending on their position and the current market price. Stop-loss orders are typically used to protect long positions, while stop-limit orders are used when investors are willing to wait for the price to rise back to the limit price.

When deciding between a stop-loss order and a stop-limit order, it is important to consider the level of risk you are willing to take. Stop-loss orders offer more flexibility, as they guarantee execution, while stop-limit orders provide more control over the execution price but may not be filled if the limit price is not reached.

In volatile markets, stop-loss orders can be problematic as they may trigger during temporary price swings and prevent investors from benefiting from subsequent upswings. In such cases, a stop-limit order may be more appropriate as it allows for more specific price targets.

Frequently asked questions