Many investors and traders do not know how toprotect their open positions in stocks, futures, and other securities. Fortunately, some simple strategies managedownside risk in both bull and bear markets. These strategies includebuy stops, buy stop-limits, sellstops, and sellstop-limits. Below are some techniques investors can use to place them effectively in anytype of market condition.
Key Takeaways
- A stop-loss order is an order placed with a broker to buy or sell once the stock reaches a certain price, designed to limit an investor's potential loss on a trading position.
- Sell-stop orders protect long positions by triggering a market sell order if the price falls below a certain level.
- Buy-stop orders are conceptually the same as sell-stops except that they are used to protect short positions.
- One key advantage of using a stop-loss order is you don't need to monitor your holdings daily.
- A disadvantage is that a short-term price fluctuation could activate the stop and trigger an unnecessary sale.
Types of Sell Stops
Sell stopand sell stop-limit orders offer two powerful methods toprotect long positions. A sell stop order, often referred to as a stop-loss order, setsa command to sell a security ifit hitsa certain price. Whenthe securityreaches the stop price, the order executes,andshares or contracts are sold at the market.The sell stop is always placed below the security'smarket price.
A sell stop-limit order setsa command to sell a securityifa specific price is reached as long as the price does not fall below the limit specified by the investor or trader. Whenthe securityreaches the stop price, the order is converted into a limit order, which is executed at the specified limit price or better. Neither order getsfilled ifthe security does not reach the specified stop price.
Putting Sell Stops in Place
The proper use of sell stop and sell stop-limit orderslowers risk and protects your investments—up to a point. These tools keep the decision-making process simple and unemotional,even when the market is in turmoil. They also improve riskmanagement skills by identifyingkey price zones in advance and increasing the conviction needed to hold firm between those actionable levels.
There are two common methods used to place sell stops, butno magic number or formula will work 100 percent of the time. Also, stops can be raised as the security gains ground.
The first method is to place the stop below the support level. Identify a support level by looking at a chart and finding where it stopped fallingduring prior downturns. A break below this priceoften meansthe security will head even lower before reversing.
The second method is to place thestop 5 to 15 percent below thepurchase price depending on the investor's comfort level. Theoretically, at least, thislowers the likelihood of a catastrophic loss. In addition,identifying the potential downside in advance allows the investor to prepare fora worst-case scenario.
Sell Orders and StoppingOut
When a securityfalls into the sell stop priceand the order is executed, this isreferred to as stoppingout. So, while sell stop and sell stop-limit orderskeep the investor on the right side of the markets, there will be times when thosestopsexecutejust before the security reverses in the intended direction.
How can you avoid this? As a general rule, avoid placing stops at round numbers, such as 10, 40, or 100,because many market participantsplace stop orders at these levels and invite trouble from opportunistic algorithms and market makers. Instead, the investor can place theorder at an odd number or in-between round numbers with enough wiggle room to surviveapotential last round of selling pressure.
For example, if many traders placesell stops on XYZ at 35. In this scenario, consider placingthesell stop at 34.75 to provide enough room for a final round of sell orders without incurring an unnecessary loss. While the investor does not know exactly where other traders will place their stops, taking crowd behavior into consideration shoulddecrease the likelihood that an investor will stop out duringa temporary downdraft.
Buy Stop and Buy Stop-limit Orders
A buy stop or buy stop-limit order protectsupside risk if a short sale position moves against the investor (goes higher in this case). Shortssellan unownedsecurity by borrowing shares or contracts from the brokerwith the goal of buying themback at a lower price to make a profit.
Conversely, the shortseller incurs a loss ifthe security rises, and the short seller isforced tobuy it back at a higher price. A buy stop order is used to limit theloss or to protect a profit on a short sale and is entered above the market price. The orderis executed at the marketif the securityreaches this price.
A buy stop-limit order coversthe short sale whena particular price is reached, at which point the order converts into a limit order. The buy stop-limitorder will only be executed at the specified limit price or better, similar to the sellstop-limit order.
Putting BuyStops in Place
Similar to sell stopand sell stop-limit orders, placing buy stopand buy stop limit orderscan be tricky. Fortunately, there are two general rules that offer useful guidance about placement:
- The investor should place the stop above the resistance level. This is the pricewhere a security has trouble moving higher. The investor can determine the resistancelevel by looking at a chart and finding where it stopped risingduring prior rallies. A breakout abovethis priceoften meansthe security will head even higherbefore reversing.
- Place thestop5 to 15 percent above the short sale price depending on the investor's comfort level. These can also be adjusted upwardto protect profits.
BuyOrders and StoppingOut
The same techniques used with sell stopand sell stop-limit orderscan be applied to buy stop and buy stop-limit orders. These include avoiding round numbers and placingorders aroundodd numbers.
For example, if many short sellersplace buystops on XYZ at 35. In this scenario, consider placingthe buystop at 35.25to provide enough room for a final round of buyorders without triggering the stop and incurring an unnecessary loss. While the investor does not know exactly where other shortswill place their stops, taking crowd behavior into consideration shoulddecrease the likelihood that the investor will stop out duringa temporary downdraft.
The Bottom Line
Traders and investors can protect themselves from volatile markets and prevent unnecessarylosses by using sell stop, sell stop-limit, buy stop,and buy stop-limit orders. Investors should take the time toadapt these tools to their comfort level and risk tolerance.
