One of the authors who has most influenced my way of understanding the markets has been Benoit Mandelbrot, not only has he been a great influencer for me, but for… MIAMI (MarketWatch) — I believe in stop loss orders to protect stock positions or to lock in gains. When the stop loss is triggered, your stock is automatically sold at the market at the best available price. The best available price? Unfortunately, that can be a misnomer.
In a normal market (if there is such a thing), the stop loss can work as intended. You buy a stock at $50, and enter a stop loss order to sell at $47.50, which limits your loss to 5%. In reality, in a fast market when the stock gaps down (during flash crashes, breaking news, or fake tweets), your stop loss is triggered. The bad news is that it will be triggered at the next available market price, which could be many points lower. In other words, your stock could be automatically sold at the lowest price, and instead of locking in a 5% loss, you could lose much more. Another problem with a stop loss order is that when you enter it into the computer, the order is transparent. A game that some market-makers played (these days, it will be computer algorithms) is “run the stops,” when the stock is forced low enough to trigger a large cluster of stop loss orders (usually at round numbers or well-known support and resistance levels). After the stock is sold at a popular stop loss price, the stock reverses direction and rallies. The biggest problem with stop losses is that you have given up control of your sell order to the computer. During volatile markets, that can cost you money. But there is an alternative. Price alertsI still believe in stop losses, but not the automatic kind. Rather than using automatic stop losses, I set up price alerts for the securities I bought (and for those I plan to buy). For example, if I buy XYZ stock at $20 per share, I might set a price alert at $19 (5% loss), and also at $25 (25% gain). If the $19 alert is triggered, I am notified by email and text message. Next, I’ll turn to my mobile device and decide what action to take. More than likely, I’ll sell depending on market conditions. And if the $25 price alert is triggered, I might sell for a profit or set new price alerts. The main point is that I am in control of my sell orders. Technology has made price alerts more practicable than in the old days. First, because of mobile devices, you are notified instantly if the target price is triggered. Second, you can take immediate action. Before the Internet, you had to run to a phone and call your brokerage firm. (During the 1987 market crash, phone lines jammed because of the huge influx of orders. By the time brokers entered their clients’ sell orders, stock prices were already at rock bottom.) Note: Stop loss orders still make sense if you are unable to access your account immediately, for example, if you are on vacation. In addition, if you are not disciplined and ignore price alerts (hoping your stock will come back one day), automatic stop losses might be a better alternative. Alert pricesNow, let’s take a look how the overall market is doing, and which are the leading stocks within the strongest sectors. Amy Smith, author of “How to Make Money in Stocks Success Stories” and a market expert at Investor’s Business Daily, gave her view of the overall market. “We’ve been in an uptrend since November and have had a nice move along the way with the indexes moving into new high ground. Although there were a few distribution days (selling), and the market corrected a little bit, we went back into an uptrend. Savvy investors are keeping a close eye on the volume going into the indexes.” Smith says to watch for heavier volume as the market moves higher. “If volume continues to increase, it indicates institutions are buying shares. The key is whether the major indexes can hold onto their new highs.” Using the CAN SLIM® investing method, Smith is also looking at how the leading stocks are doing. Are they holding or starting to correct? So far, they are holding on, but that could quickly change. “If you see indexes and leading stocks pulling back on heavier volume, that is an indication that professional buyers are lightening their positions,” Smith says. “That is the time you don’t want to be in the market.” One group to watch: Biomedical stocks. These companies produce drugs and services to people that need health care. “We have an aging population and people need these products,” Smith says, “but if this group begins to weaken, that could also spell trouble for the overall market unless another sector takes its place.” According to Smith, stocks in that sector that have had huge earnings increases so far (ranging from 27% to 63%) include Celgene US:CELG , The Medicines Company US:MDCO , Valeant Pharmaceuticals International US:VRX , Cigna CI , and Biogen Idec BIIB . There are also several ETFs that focus on biomedical stocks. As always, just because this industry has done well in the past is no guarantee it will do well in the future. My opinion: Many retail investors are still suspicious of this market. Why? Because they think the market is logical. Well, if you want logic, play chess. Otherwise, until there is evidence of a correction or bear market (indicators turning down, more than two strong down days in a row, strong opening but weak close, and leading stocks unable to advance), this bull market will continue. That said, never let down your guard — this market could turn at any time. Michael Sincere is the author of “Understanding Options,” “All About Market Indicators,” and “Understanding Stocks.” On his website, he lists signals from the most popular market indicators. Michael Sincere and Amy Smith do not own shares of the stocks noted in this article. 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?
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.
Brokerages execute a variety of stock order types for investors to buy and sell stocks. Most of these order types indicate to the broker an investor's preference to purchase or sell a stock at a desired (or better) price. Other order types enable investors to reduce their risk of losses on trades. A stop-loss order is a type of stock order that enables an investor to limit the potential loss on a stock position by setting a price limit that triggers the stock's trade. A stop-loss order triggers the sale of a stock (or a purchase for investors buying to cover a short position) once the stock's price reaches a certain value. Investors create stop-loss orders to automatically sell stocks (or cover short positions) once the stock's price reaches the trigger price set by the stop-loss order. Stop-loss order exampleInvestors often use stop-loss orders to limit their losses on new positions. Let's say an investor purchases 100 shares of a hot new tech stock of a company that recently completed its initial public offering (IPO) at $25 per share. To limit the potential loss on this stock purchase, the investor sets a stop-loss order at 20% below the purchase price, which equals $20 per share. If the price of the red-hot tech stock declines to $20, then that triggers the investor's stop-loss order. The investor's broker proceeds to sell the stock at the prevailing market price, which may be exactly at the $20 trigger price but can be much lower, depending on the the nature and timing of the stock's price movements. Advantages of the stop-loss orderInvestors use stop-loss orders as part of disciplined strategies to exit stock positions if they don't perform as expected. Stop-loss orders enable investors to make pre-determined decisions to sell, which helps them avoid letting their emotions influence their investment decisions. Other advantages of a stop-loss order include:
Disadvantages of the stop-loss orderThere are disadvantages to using stop-loss orders. First, establishing a stop-loss order doesn't limit an investor's loss to the difference between the purchase price and the pre-determined sale price. If a company reports disappointing earnings after the market closes, for example, then its share price by the start of the next trading day could be well below an investor's stop-loss price. Another potential pitfall of stop-loss orders is that they can trigger a stock sale even if the stock's price dips only slightly below the trigger price before quickly recovering. If a stock's price is volatile or another event occurs that causes a brief sell-off by other investors, that can trigger an investor's stop-loss order. Finally, during sharp market declines, sophisticated investors like hedge fund operators sometimes try to take advantage of the existence of stop-loss orders. Known as "stop hunting," traders short stocks already in decline in order to push prices lower in an attempt to trigger a flood of stop-loss orders. These investors subsequently start buying those same stocks to profit from an expected rebound. Why do investors use stop-loss orders?Investors primarily use stop-loss orders to limit their losses on stock positions and reduce their portfolio risks. While stop-loss orders can be useful, it's important to realize they don't always work as intended. Stop-loss orders can also lock in avoidable losses, which is why The Motley Fool favors buying and holding quality stocks to build wealth over long periods of time. |
