Stocks are a tricky business, especially when the market is volatile. When you have money in an investment, you want to be sure it is benefiting you. Falling stock prices means you could lose money on your investments, which is something all investors want to avoid.
Establishing a stop-loss
To reduce the risk of losing money, many people use stop-loss orders. These are specific instructions to sell your position if the price ever drops to a predetermined amount. They protect investors from losing more money than they can afford to.
Here's how they work: If you purchase a stock at a certain amount of money, say $20, and you want to make sure you don't lose more than 5 percent of your investment, you'll want to set your stop-loss order at $19. If the stock falls to $19 or below, it is automatically sold at the best market price at the moment.
According to Stock Trader, there are many reasons a person would want to set a stop-loss order. Doing so allows the trader to focus on other matters in his or her life, even during times of market volatility. This is because stop-losses don't need the investor to be present; they are completely automated.
Investors also like this technique because it removes all emotion and the possibility of over-thinking a sell. Investing can become an emotional trigger for some, resulting in poor practice and, eventually, loss. Creating a stop-loss is purely logical, which is important in an industry that requires discipline to succeed.
ABC News recommended that all investors establish their stop-loss orders immediately after buying their stocks [2]. Stock Trader explained that stop-loss orders should never be set above 5 percent [3]. This is to avoid selling unnecessarily during small fluctuations in the market. Realistically, a stock could fall by 5 percent midday, but rebound. You wouldn't want to sell prematurely and lose out on potential gains. ABC News noted that lower percentage increments should be issued for fixed-income investments, like bonds. On the other hand, stop-losses on emerging market opportunities will typically be set at higher price increments.
Also, it's important to set stop-losses at common prices. A stock may never reach an obscure price, such as an odd dollar amount or an amount that isn't divisible by quarters.
When not to use a stop-loss
According to Stock Trader, there are some instances when a stop-loss order isn't helpful, and others when it may actually be harmful to the trader's investment.
If an investor is an active trader dedicated to his or her stocks and constantly watching the market, and ready at any time to buy or sell, a stop-loss order is essentially pointless. The trader likely knows when the stock is reaching the threshold for more loss than wanted and will sell it when the time is right.
Michael Sincere, a columnist for Marketwatch, explained he stopped using stop-losses altogether when he realized he could execute sales in an efficient and timely manner by taking advantage of technology [4]. Instead, he has price alerts for those amounts he would have previously set his stop-losses at. When a stock he owns reaches the limit, he gets an email and a text message. He is able to immediately access his properties and decide to sell, or not.
Sincere explained he likes this strategy better because it protects his stocks from abnormal market fluctuations that are likely to correct themselves. If a stop-loss is in play during these times, the investor could wind up losing more money than expected, if the stock is sold at a much lower price. It also provides protection against stocks that are forced down in order to trigger a large group of stop-losses. In these instances, the price will likely begin to increase shortly after.
However, he did note that, if an investor has limited access to his or her stocks, such as during travel or vacation, a stop-loss will add a layer of protection against major losses. Also, if a trader knows he or she won't promptly respond to the price alert, a stop-loss might be a better strategy.
The objective of investing in the stock market is to make money - not lose it. A stop-loss can be viewed as a sort of insurance against falling stock prices.
Sources:
[1]. Investors Guide to Stop Loss Orders
[2]. Secrets of Managing Your Investment Portfolio
[3]. 10 Great Tips For Using Stop Loss Orders Successfully
[4]. Why I stopped using stop loss orders
