The last thing you want from the stock market is losses, but the harsh reality is that stocks will rise and fall. Because nobody can tell the future, nobody will make accurate predictions 100% of the time, especially when it comes to investing.
Although losses will occur from time to time, tools were created to ensure you don’t take too much of a hit when declines happen in your portfolio.
The most effective of these tools is the stop-loss order. Stop-loss orders limit potential losses by triggering market orders to exit positions when a price falls to a pre-specified threshold. But where exactly should you set these thresholds, how do you place this type of order, and are there any limitations?
Where Should I Set My Stop-Loss?
When setting a stop-loss level, it’s important to consider your comfort with risk and the volatility, or price fluctuations, generally experienced in the asset you’re investing in. You don’t want to experience price drops below levels you’re comfortable with, but it’s also important to remember that some of the biggest opportunities happen in high-volatility assets whose prices may swing dramatically.
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There are several methods for choosing a stop-loss that can be added to your investment strategy. Three of the most common are:
1. Percentage Method
The percentage method is one of the best risk management tools for beginners due to its stringent focus on the investor’s comfort with risk, rather than the general volatility of the stock. Because this method is geared toward investor preference, it requires no technical analysis to use.
All you need to do is determine the percentage of your money you’d be comfortable losing on each investment in a worst case scenario.
For example, say John buys 100 shares of ABC stock at the current market price of $10 per share, for a total of $1,000. In a worst case scenario, he is comfortable with losing 15%, or $150, on the trade. John decides to place a stop-loss order that will turn into a market order to sell the shares if the share price falls 15% to $8.50.
If the share price goes up and the stock never falls to $8.50 per share, John will keep the shares until he decides to sell. On the other hand, if the stock price does fall to $8.50, a market order to sell his 100 shares of ABC will be placed automatically, leaving John with a theoretical maximum loss of $150.
The percentage method is best used with a trailing stop-loss. This means that the trigger point for the trade rises as the stock price rises, limiting losses and, in some cases, locking in gains.
Using the example above, if ABC stock grew to be worth $17.50 over the next three years, John’s 15% trailing stop-loss trigger would have risen to $14.88 per share. So if the stock then plummeted to $11, John’s stop-loss order would trigger at $14.88. That would leave him with $1,488, a net profit of $488, instead of a position worth $1,100.
2. Support Method
The support method is a bit more intuitive, requiring the use of technical analysis to determine the stop-loss price, making it best for intermediate and expert investors.
Support is a technical indicator that outlines the price at which a falling stock price is likely to reverse directions and head back upward. In most cases, that’s exactly what happens, but in some cases, the declines continue past support. Historically, when support is broken, the price of the stock continues lower, often leading to mounting losses.
The support method suggests investors should place their stop-loss triggers just below key support levels. In doing so, if support is broken, you aren’t in for a wild ride downward with the rest of the crowd. On the other hand, if the share price reaches support and bounces back, you’re still in a position to benefit.
The support method is best used with investing and trading strategies focused on high-volatility financial assets like penny stocks, small-cap stocks, and currencies.
Because support is a theoretical measure, and there are a multitude of methods for finding support on a stock chart, the investor must decide which method works best and employ it relatively regularly to keep the stop-loss squarely below support.
Fast-paced swings in these assets may not be comfortable for a beginner or risk-averse investor, but even those willing to take on the risks to generate larger returns should take advantage of protective measures when investing. Stop-loss orders below important support levels give you exactly that.
3. Moving Average Method
The moving average method is another technical method that’s focused more on market trends than investor risk tolerance.
A moving average is the average price of a financial asset over a predetermined period of time. For example, a 30-day moving average will average the closing price of a stock over the past 30 days. When the stock closes today, the oldest number in the average will be removed and today’s closing price will be added in.
Based on the nature of a moving average, using one as a stop-loss creates a trailing stop-loss of sorts because moving averages change over time, following price movements in the stock.
The moving average method generally takes one of two forms:
- Price Touches Moving Average: A price touching moving average is a stop-loss order that’s triggered the moment the price of the asset reaches the moving average. On long positions, this event will trigger a sell order, or buy orders will be triggered to cover short positions.
- Price Crosses Moving Average: This is the more common of the two. Most investors prefer to set a stop-loss order to trigger when the price of the asset actually crosses above or below the moving average. That’s because moving averages tend to act as support. If a position is closed as soon as the price touches the moving average, there’s no potential to recover losses if it immediately rebounds off this support.
When using either of these moving average methods, long-term moving averages are generally best because they weed out the noise of volatility in the market. Moving averages ranging between 60 and 180 days are generally the best options. The shorter the moving average you use, the more likely a stop-loss event is to be triggered; the longer the moving average you use, the more volatility and risk you’ll have to accept.
How to Set a Stop-Loss
Setting up a stop-loss is a pretty simple process, provided your brokerage provides this order type. Here’s how it’s done:
Identify Your Stop-Loss Strategy
The first thing you’ll want to do is identify the strategy you’ll be using when determining where your stop-loss will be triggered. While you have the option to use any of the methods outlined above, each is generally best for a specific type of investor.
- Percentage Method: Perfect for beginners with little comfort with technical analysis, and for intermediate investors with little appetite for risk or who aren’t comfortable with their technical analysis skills yet.
- Support Method: Ideal for more experienced investors who are comfortable with their understanding of technical signals and confident in their charting capabilities.
- Moving Average Method: Appropriate for investors of any skill level. There are plenty of trading platforms that offer the ability to set stop-losses automatically based on the stock’s price in relation to a specified moving average.
Placing Your Stop-Loss
The process for placing a stop-loss order differs slightly from one trading platform to the next, but the steps are generally pretty similar.
- Step #1: Launch Your Trading Platform. The vast majority of trading platforms offer stop-loss order types. If yours doesn’t, you’ll need to open an account with a broker or platform that does.
- Step #2: Purchase the Stock if It’s Not Already Owned. You can’t place a stop-loss order until you have a position in the stock.
- Step #3: Create an Order. If you’re placing a stop-loss on a long position, initiate a sell order for your shares. If you’re working with a short position, your stop-loss order will be set up as a buy order.
- Step #4: Choose Stop Order Type. While setting up your order, look for the option to change “order type” or place a conditional order. Depending on your broker or platform, you may have to click a menu to open conditional order types. Once conditional order types are in view, choose “Stop Order.”
- Step #5: Set Your Stop Price. Now set the price at which you want the position to close. If your broker or trading platform offers them, this is where you’ll see options like “Price Touches Moving Average” and “Price Crosses Moving Average.” You can also manually enter a price where you want to set your limit.
- Step #6: Set Time in Force. You must choose how long your stop-loss will remain active. Good until close makes the order last only through the current training session, whereas good until canceled leaves the order in place until it executes or you cancel it. Keep in mind, even if you select “good until canceled,” there is generally a time limit of around 90 days on these orders. If they aren’t executed by then, you’ll need to set a new stop-loss.
- Step #7: Enter Number of Shares. Specify the number of shares you would like to exit should the stop-loss be triggered. You can place a stop-loss on your entire holdings of an asset or just a portion of it.
- Step #8: Review & Submit Your Order. Finally, review your order and click submit once you’re sure all parameters are correct.
Different Stop-Loss Order Types
When you start working with stop-loss orders, you’ll find there are multiple order types. Each order type offers different levels of protection and risk. The most common include:
- Stop Loss. The traditional stop loss places a market order to sell an asset once its price reaches or crosses below the trigger price.
- Stop Limit. A stop-limit order sets a price range at which the asset should be sold. For example, with a stop-limit order, you can set a traditional stop-loss trigger at $50 to place a limit order at $45, meaning if the stock falls from $51 to $41 on bad news before the market opens, you won’t be forced to accept the larger-than-expected losses. Instead, the premarket decline will trigger a limit order to sell at $45, meaning you’ll hold onto the shares until a rebound to $45 takes place.
- Trailing Stop. Finally, trailing stop orders move with the price of the stock. These are the types of orders used in the percentage and moving average methods.
Limitations to Stop-Loss Protection
Although stop-loss orders are designed to protect you, there are some limitations you should consider before you rely on them. The most important are:
- Accessibility. Not all trading platforms offer stop-loss functionality, and even if they do, they may not offer the type of stop-loss order you’re looking for. You’ll need to do your research on trading platform options if yours doesn’t offer what you’re looking for.
- Brokerage Fees. Some brokers charge different fees for different types of trades. Make sure you know what you’re paying to make trades before executing them.
- Losses May Be Larger Than Expected. Unless you use stop-limit orders, there’s no limit price on stop orders. If a stock price drops sharply or before or after the market closes, you could sell your shares for significantly lower than your stop price.
- Stop-Limit Orders May Prolong Agony. If you do use a stop-limit order and after-hours or premarket prices fall below your limit price, the position will not be exited. If the underlying company never recovers, you may end up with extensive losses while you wait for a recovery to your limit price.
Even with the limitations that come with the tool, stop losses are an important form of risk management that all investors should take advantage of. These order types offer a form of insurance, protecting investors from big losses that are hard to come back from.
It’s important to keep in mind that even great investors like Warren Buffett and George Soros make mistakes. However, these greats also know they’re not perfect and practice risk management to ensure mistakes don’t lead to losses that are too painful. There’s no reason you shouldn’t do the same.