Stop/Loss Orders - Are They Right for You?

Here's a scenario for you...

You've just bought a smokin' hot stock (ticker REDHOT) for $100/share, but you're a little nervous.  If you're like me, buying REDHOT shares today means REDHOT almost certainly will trade lower tomorrow.  Worse yet, will REDHOT tank?  Will you lose all your money?  JUMPING JEHOSEPHAT!!

Down to Business...

When you go to sell shares of a stock and you select your order type, you may notice "Stop Market" or "Stop Limit" order types.  The concept behind "Stop Loss" or "Stop" sell orders is this: if the stock price drops to the activation price, a sell order is triggered automatically.  By using a stop loss sell order you can, with some pre-planning, protect your capital in the event of a stock price drop (even if you aren't in front of your PC watching quotes all day).  Here's a situation where that might prove valuable...

You buy 100 shares of REDHOT for $100 / share because you're looking to make some crazy cash, but if the stock doesn't rise right away you're packin' your REDHOT bags.  You decide that if REDHOT drops to $98 / share, you want to sell your stock automatically for whatever the market is willing to pay at that moment.  After purchasing the shares, you immediately place a "Stop Market" sell order to sell all your shares if the stock drops to an activation price of $98.

Incidentally, REDHOT cools down and falls from $100/share to $92/share the next day.  That means that the stock traded at your activation price, which means your sell order got triggered.  Maybe your 100 shares sold for $97.98/share.

In this example, here's what happened in money terms:

Initial buy: 100 shares x $100/share = $10,000 invested
Sale executed: 100 shares x $97.98 = $9,798 left; => loss of ($10,000 - $9,798) = $202.
Value with no stop loss order: 100 shares x $92/share = $9200; => paper loss of ($10,000 - $9,200) = $800.

Not great, but not bad. The stock didn't rise right away and instead it tanked, costing you $202 instead of a more depressing $800.

Sounds like a dream come true?

Not so fast!

Depending on the type of investment you're making, using stop loss orders may not make the most sense.  One "stop loss" rule I keep in mind isn't right all the time, but I think it's reasonable:

If you're making what you consider to be a risky (quick? super-growth?) stock trade, consider using a stop loss order.  If you're smack-dab in the middle of a long-term value investment, stop loss orders might not be most sensible way to go.

Why do I like that general rule?

If I'm in the middle of a long term value investment, chances are I've put some thought into how much I think a stock is worth.  I'm owning the stock in the first place because I trust my judgment that the stock is headed higher.  If the stock has reached a point where I'm concerned it may drop lower (in other words, maybe it's reached a valuation I find fair or even rich), why sell lower when I could sell now for more profit?  Thanks, Grandpa Stan.

Time for another example.  Suppose I own a stock with ticker BESTVAL.  BESTVAL is trading at $50/share, and I had purchased the stock at $42/share. I figure $50/share is a high valuation, and I'm afraid BESTVAL is going to drop soon.  Since profit is the name of the game, logic tells me to sell BESTVAL at the highest available price (buy low and sell high, right?).  By entering a stop loss order with an activation price of let's say $48 / share, I could end up selling the stock at a price that's 4% lower than the current price.  What gives?  I'll take my $50/share, thank you very much.

Conclusion

How you approach your trades is 100% up to you, but you may want to consider these examples when making some order type selection decisions.

Happy investing!

Full disclosure: BESTVAL and REDHOT are not real stock tickers. So, yeah...

(P.S. for more information on order types, check out the wikipedia page on stock orders)