“I focus only on what I can control – my next shot. Not the things I can’t.” Tiger Woods
Here is a quote from a recent article in a financial investing website:
“A stop loss quote order does not guarantee your security is sold at the pre-specified price. It merely places a market order to sell when the market hits the pre-specified price. The market order can execute far below where it was intended to execute because it relies on there being a bid there.”
The writer then goes on to use the example of a pharma company that just failed its drug trial. Stating that the price of that company’s stock could quickly drop as much as 20%, thereby triggering your stop loss. He then goes on to show that even if you had a stop loss set at 5%, it could fall right through that point.
While both of those statements may be true, in my experience, they are far from the norm and applying this approach as a general rule would be a mistake.
Here is why. Let’s play out that scenario.
- The stock’s price starts to drop quickly and you’re not aware
- Before you realize that something has happened, your broker’s system has acted on your Stop Loss Order and placed a Market Sell order on your behalf
- The price falls so quickly that it falls below the price at which your Stop Order was initiated, and eventually sells
- As a Market Order, your sell order will be executed as soon as there is a buy order for that stock
- The execution price may be lower than you would have liked, but you will have been able to sell. Also, your sale would occur well before another investor who didn’t have a stop loss in place and initiated a sell order in reaction to news about the stock
- It is quite possible that the sale price you received involved a profit
- Finally, if you were a Trend Follower and had applied diversification to your portfolio, any loss, although regrettable, would probably not have inflected any significant damage, to your overall account
A personal example
I had invested in Aetna stock and placed a stop loss order that I thought was reasonable at the time. There was an offer to buy the company and the stock took off.
When the stockholders rejected the offer, the stock price plummeted and went right through my stop loss. In the end, I still made a profit but not nearly as much.
This was the only time, in all of the years I have been investing, that the sale price pierced the stop loss order by more than a few dollars.
In summary, the writer, perhaps in an effort to encourage caution, is providing this unusual pharma example as justification to not use stop loss orders.
He’s suggesting that you should no longer use Stops. As an alternative to the safety and peace of mind provided by the Stop Loss he suggests – nothing.
Now there’s an interesting alternative – Do Nothing! That is not the solution.
Why would an investor not use a stop loss?
- They aren’t sure at what price to place it
- They are afraid that the stock may stop out and be sold, yet they really like having the stock of that company
Trending Stocks can definitely help with both situations.
First, a stop loss is calculated for every stock based on that individual stock’s recent volatility, so no guess work.
In the second scenario, there may be a reason for the emotional attachment, for example, it may have been a wonderful place to work for you or a family member.
Here is an option. In order to have some level of risk management, place a stop loss order for 50% or half of the shares owned. That way if the stock takes a big dip you will have the cash associated with the 50% sold.
When the company’s stock price levels out and starts recovering, you can buy back even more shares given its lower price and your cash position. Or buy the shares of another company. In either case you have the cash to do so!
Once you learn how to place Trailing Stop Loss Orders, you will always employ them and will avoid making the mistake of not using them!
One of our primary goals is to help investors manage risk and lock in profits. Stop Loss Orders, especially Trailing Stops, are a great way to do that. Charles Schwab agrees.
Always remember – Ride Your Winners; Cut Your Losses! And start that FREE 4 Week Trial!