It is easy to get overwhelmed when dealing with investing. With so much to attend to it can be far too easy to overlook the small things. One such small thing that can make a huge difference is the stop-loss order.
Not every trade is going to be a winner. Those are tough words to hear, but they are true. You can do all of the research, make all of the right decisions, and still a stock can lose money. But what some people don’t realize is that an investor can lose money on seven out of ten stock picks and still come out ahead if their total losses are less than their total gains.
While that may seem simple, there are some things that stand in the way of investors actualizing that advice – namely, themselves. Often emotion and fear control investing decisions, usually with terrible results. A stop-loss order takes the emotion out of investing, and therefore increases your chances of making money.
Setting A Stop-Loss Order
A stop-loss order is an order that is placed with your online broker that is intended to contain an investor’s loss in on an investment. If you st the stop-loss order for 10-15% lower than the price you payed for the stock you will limit your losses to 10-15%.
An advantage to using a stop-loss order is that it eliminates the need to monitor the performance of a security on a daily basis. Stop-loss orders are especially useful if you are in a position that keeps you from overseeing your investments for a long time, such as being on vacation.
On the other hand, a stop price could be triggered by short-term fluctuations in a stock’s price. Your objective is to chose a percentage that permits day-to-day fluctuations while limiting downside risk. By setting a stop-loss order for 5% on a security that is known to fluctuate by 10% or more is not a good idea. It is highly likely that commissions alone will cause you to lose money.
When figuring out how to set a stop-loss order for stocks, the percentage that you set for your order varies depending on your investment strategy, objectives, and risk tolerance. While a long-term investor may use 15%, a more active trader may set a level of 5%.
When a stop price is reached, your order turns into a market order. This means that there is a chance that the price for which you sell your stock could be considerably different from the stop price. In a quick moving market this can be especially true.
It is important to realize that many brokerages do not permit stop-loss orders on specific stocks such as penny stocks or OTC Bulletin Board stocks.
Using Stop-Loss Orders To Lock In Profits
While traditionally thought of as a way to avoid losses, this tool can also be used to lock in profits. When used this way it is referred to as a “trailing stop”. With a “trailing stop”, the order is set at a level that is a percentage below the current market quote price, not the cost of the stock when you purchased it.
If a stock price rises, you have what is referred to as an unrealized gain. This means that you do not realize profits until the security is sold. By utilizing a trailing stop order you can allow profits to run while at the same time ensuring some realized capital gains.
Stop-Loss Order Advantages
With a stop-loss order you are, in essence, receiving free insurance, as your normal commission is charged when the order is executed. Perhaps most importantly, a stop-loss order frees you from making emotional decisions, and assists you in effectively implementing your investment strategy.
You should always remember why you own a stock in the first place. Depending on your investment objectives, your criteria will vary, as will your stop-loss levels. The important thing to keep in mind is that most investing styles can benefit from this tool, whether used to lock in gains or control losses.
Stop-loss orders are not a guarantee that you will make money. You are still required to perform due diligence, monitor your investments, and make decisions that best suit your investment objectives.