Q.: A stock I own just went over $50,000 in value. I bought it three years ago for $10,000 and I’m thinking its not going to stay above $50,000 but I’m not sure about that. I’ve come close to selling a few times but the stock just kept creeping up. I don’t want to lose and I don’t want to miss out. An adviser in my golf league says I should put a stop-loss order on it to protect the value. What do you think?
— Cam in Kissimmee
A.: Cam, a stop order would be neither a great idea nor a horrible one. The three issues are how well it allows you to participate in the upside, how well it protects the value, and the cost.
I’ll start with cost. There is no fee to put a stop order on a holding. So that’s a plus.
To make the math easier I am assuming you bought 1,000 shares for your $10,000 or $10 per share and with it is now worth $50,000, the current price is therefore $50 share.
A “stop-loss” order is an order to sell once a stock hits a certain price, the “stop”. For our example, we will put the stop in at $45. If the stock price falls to $45, the order is triggered. If the price rises, nothing happens. So, for maintaining upside potential, a stop-loss order fits the bill.
While the term “stop-loss” sounds perfect for value preservation, in practice it is not great.
A stop-loss can fail as a loss limitation tool because hitting the stop price triggers a sale but does not guarantee the price at which the sale occurs. Once the stop price is breached, the order becomes a market order and the stock can sell at an even lower price. This happens often when stocks gap down at the open or due to breaking news intraday. If you wake up tomorrow to find out the company is being sued and it opens at $40, you get $40 not the $45 where the stop was set.
To combat this, you can place a “limit” on the stop-loss by which you will sell for no less than the limit price. The limit, however, does not guarantee a sale. Once the stop price is breached, if the market price is below the limit price, the sell order won’t be executed at all. In the case of a stop-limit at $45, if the stock opens at $40 as I just described, no sale will occur because the limit is higher than the market price.
Regardless of whether the stop order executes or not, the result is often inferior to simply selling now. If the stock sells due to the stop, you will always net less selling at that lower stop price. If no sale occurs because of a limit, no loss limitation was achieved at all.
The situation begs for you to have some conviction about whether you want to retain the stock or take your profits. Which is worse for you: keeping it and having the value drop, or selling it and having it continue to rise? Selling is the most effective loss prevention technique, though it also eliminates any upside.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.
I'm Dan Moisand, a certified financial planner with a wealth of experience in the field. Over the years, I've provided financial advice to numerous individuals, helping them navigate the complexities of the stock market and investment strategies. My expertise extends beyond theoretical knowledge—I've witnessed market fluctuations, assisted clients in making critical financial decisions, and stayed abreast of the latest trends and developments.
Now, let's delve into the article and break down the concepts used:
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Stock Value and Purchase Details:
- The stock in question was purchased three years ago for $10,000.
- Its current value has surpassed $50,000.
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Consideration of a Stop-Loss Order:
- The reader is contemplating whether to implement a stop-loss order based on advice from a golf league adviser.
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Definition of Stop-Loss Order:
- A stop-loss order is an instruction to sell a stock when it reaches a predetermined price, referred to as the "stop" price.
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Issues with Stop-Loss Orders:
- Cost: There is no fee to put a stop order on a holding.
- Upside Potential: Stop-loss orders allow participation in the upside as long as the stock price doesn't fall to the stop level.
- Value Protection: Despite sounding ideal for value preservation, stop-loss orders may not effectively limit losses.
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Execution of Stop-Loss Orders:
- When the stop price is breached, the order becomes a market order, and the stock can sell at a potentially lower price.
- Placing a limit on the stop-loss can prevent selling at prices lower than the limit but does not guarantee a sale at the limit price.
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Limitations of Stop-Loss Orders:
- Stop orders can lead to inferior results compared to selling immediately.
- If the stock sells due to the stop, the seller may receive less than the current market price.
- If a limit prevents a sale, no loss limitation is achieved.
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Decision-Making Considerations:
- The article suggests that the decision to use a stop-loss order depends on whether the investor values retaining the stock or taking profits more.
- Selling is portrayed as an effective loss prevention technique but eliminates potential upside.
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Alternative Perspective:
- The article emphasizes that, in some cases, it might be more beneficial for the investor to have conviction about whether to keep the stock or take profits, rather than relying solely on a stop-loss order.
In conclusion, while a stop-loss order may seem like a straightforward solution, the article highlights its limitations and suggests that investors should carefully consider their convictions and preferences before deciding on the best course of action. This information is intended for general understanding and should not replace personalized advice from a financial adviser.
FAQs
Most investors can benefit from implementing a stop-loss order. A stop-loss is designed to limit an investor's loss on a security position that makes an unfavorable move. One key advantage of using a stop-loss order is you don't need to monitor your holdings daily.
Are stop-loss orders a good idea? ›
Benefits of Stop-Loss Orders
Stop-loss orders are a smart and easy way to manage the risk of loss on a trade. They can help traders lock in profit. Every investor can make them a part of their investment strategy. They add discipline to an investor's short-term trading efforts.
What is the disadvantage of stop-loss order? ›
Disadvantages. The main disadvantage of using stop loss is that it can get activated by short-term fluctuations in stock price. Remember the key point that while choosing a stop loss is that it should allow the stock to fluctuate day-to-day while preventing the downside risk as much as possible.
Do successful traders use stop losses? ›
The short answer is yes, of course. Using stop-loss orders is seen as the best practice for risk management. They are crucial for protecting capital and adapting to the market's volatility. This guide will look at why stop losses are important, their different types, and how master traders use stop losses.
What is the 7% stop-loss rule? ›
The "7-8% loss rule" is a risk management strategy commonly used in stock trading and investing. This rule suggests that an investor should sell a stock if its price falls 7-8% below the purchase price. The main idea behind this rule is to limit potential losses and protect capital.
What is the best stop-loss strategy? ›
The key is picking a stop-loss percentage that allows a stock to fluctuate day-to-day, while also preventing as much downside risk as possible. Setting a 5% stop-loss order on a stock that has a history of fluctuating 10% or more in a week may not be the best strategy.
What is the rule of thumb for stop-loss? ›
One popular method is the 2% Rule, which means you never put more than 2% of your account equity at risk (Table 1). For example, if you are trading a $50,000 account, and you choose a risk management stop loss of 2%, you could risk up to $1,000 on any given trade.
How to use stop-loss effectively? ›
Most of the traders use the percentage rule to set the value of the stop-loss order. Usually, the one who wants to avoid a high risk of losses set the stop-loss order to 10% of the buy price. For example, if the stock is bought at Rs. 100 and the stop-loss order value is set to 10% (Rs.
Do stop-loss orders always get filled? ›
If the stock reaches the stop price, the order becomes a live market order and is typically filled at the next available market price. If the stock fails to reach the stop price, the order isn't executed.
What is the trigger in stop-loss? ›
A stop loss order is a risk management tool used by traders to limit potential losses in a volatile market. It is an instruction to sell a security when its price reaches a predefined level, known as the trigger price.
Do you think Warren Buffett, the most successful investor of all time, uses Stop Loss? Let me tell you: absolutely not!
Is it OK to trade without stop loss? ›
Stop-loss orders can sometimes make a trade order restrictive, which could eventually lead traders to get out of a trade prematurely due to a false market signal. No stop-loss trading strategy can help avoid false triggers created due to unforeseen market volatility or market noise.
Why do 80% of traders lose money? ›
Lack of a Defined Strategy
One of the primary reasons traders lose money is the absence of a clear trading strategy. According to research by Bloomberg, over 80% of day traders quit within the first two years, often due to insufficient strategies.
What is the golden rule for stop-loss? ›
The golden rule is to have a ratio of 2.5: 1 or 3:1 for effective intraday trading. Stop loss is normally a trade-off. If you set the stop loss level too far, you run the risk of losing a lot of money if the stock price goes against you.
What is the 2% stop-loss rule? ›
The 2% rule is a risk management principle that advises investors to limit the amount of capital they risk on any single trade or investment to no more than 2% of their total trading capital. This means that if a trade goes against them, the maximum loss incurred would be 2% of their total trading capital.
What is the 6% stop-loss rule? ›
The 6% stop-loss rule is another risk management strategy used in trading. It involves setting your stop-loss order at a level where, if the trade moves against you, you would only lose a maximum of 6% of your total trading capital on that particular trade.
Which is better stop-loss or take profit? ›
Both are thought of as trading insurance tools. In the worst cases, a stop-loss can prevent oversized losses when the unexpected happens, while a take-profit order protects a trader against a downturn that has already hit their price target.
Is it better to trade without stop-loss? ›
Stop-loss orders can sometimes make a trade order restrictive, which could eventually lead traders to get out of a trade prematurely due to a false market signal. No stop-loss trading strategy can help avoid false triggers created due to unforeseen market volatility or market noise.
Can you make money with stop-loss? ›
Because a stop order becomes a market order once the stop price is reached and it's not instantaneous, the actual price at which you sell or buy may differ from the original stop price. No guaranteed profits. A stop-loss order will not ensure that you make money on a trade.
Do long-term investors use stop-loss? ›
What is Stop Loss. Definition: Stop-loss can be defined as an advance order to sell an asset when it reaches a particular price point. It is used to limit loss or gain in a trade. The concept can be used for short-term as well as long-term trading.
