Stop Loss

Celticheart Investor

A beginner's guide to trading and investing

Setting a stop loss is one of those things that, at first glance seems like a great idea but when you look into it in  greater depth can be less appealing. So what exactly is a stop loss you might ask?

A stop loss is any order that you place with your broker or automatically online to sell a security when it drops below a pre-set price. The idea is to limit your losses in the event of a sudden drop in price. This is also know as a stop order or a stop-market order but to be honest the term generally used is stop loss.

So what could possibly be wrong with a system designed to reduce your risk of losing money, after all risk reduction is what it is all about? The problem is this, imaging that you stop monitoring your shares for a while whether for a day, a week or a month having set your stop loss at say 15% below the current price.

While you are gone the price drops dramatically for a very short period of time, maybe because of profit taking, bad news or just rumour. Regardless of the reason behind the drop if it falls below your set limit your shares will be sold.

You will have lost 15% of the value of your holding but 85% (less the trading fee) will still be intact, in cash, back in your account. The problem arises if this was little more than a temporary drop caused by sentiment rather than any major catastrophy so the shareprice recovers, possibly even back to the level you left it at or higher.

You return to your holding to find that not only are you 15% down on your investment but  to buy back in will cost you even more, as usually the Ask (buying price) is higher than the Bid (selling price). So what seemed like a good idea has in fact turned out to be a bad thing.

Now I am not saying that stop losses do not work, of course they do, in the event of a sustainable drop in the price you will have limited the damage to your funds possibly even getting the opportunity to buy back in cheaper.

This is where it gets tricky, how do you decide when a stop loss is a good thing or not? I would suggest that, as with much to do with investing (or trading) that there is no simple answer except that the more volatile a share is the more likely it is that you will get spikes and retracements so the more likely you are to trigger your stop losses.

If you ask the more savvy investors they will tell you that it is not uncommon for a share to come under an attack often referred to as a "stop loss raid", where a price is deliberately driven down to trigger stop losses and as a result free up shares which will inevitably then be bought cheaply. Whether or not this is just one of those myths associated with trading or not it is impossible to say and even more impossible to prove, suffice to say it does appear to happen more when a security is in demand.

One way of protecting yourself is to monitor the volatility of a share which many charting packages will allow you to do. If the security is high in volatility then you are probably best to ride the peaks and troughs but if it is low in volatility then a sudden drop could be significant so worthy of setting a stop loss. Ultimately only you can decide the risk level you are prepared to take and whether setting a stop loss is the right course of action for you.

It is probably worth mentioning that stop losses can also work when shorting a security by limiting the price at which the share is bought but the same risk applies with a spike triggering your purchase at a higher price than you wanted to pay. Personally I do not "short" a stock but many do so worth a mention.

A stop loss can of course also be used positively to lock in profits by setting a sell price at a level of profit you are happy with lets say 10%. In a volatile market where spikes are common you might decide that it is worth ensuring you gain some profit rather than miss out on selling on a spike, the danger here of course is that you sell prematurely and miss out on a much bigger profit.

You can of course set what is called a "trailing stop loss" where the stop loss level tracks the current shareprice by a fixed percent for a given period of time making the risk of getting caught out less likely.

Next time:  Communication

A cautionary note, trading and investing in shares carries a level of risk, these blogs are only meant as a basic guideline to investing and trading, always do your own research and base your decisions on what you can afford to lose. This blog is not intended to provide financial advice as I am not qualified to do so, it is simply designed to provide information about how the markets work that might be of some help to private investors like myself.