Stop-loss orders can be beneficial

A “stop-loss” sell order is an industry term, used to trigger an automatic sell of an investment once it reaches a specified price.  A stop-loss sell order is below the current market price.  Why would anyone set an order to sell a stock for lower than the current market value?

Stop-loss orders are entered to either protect profits or limit losses for investors who want to continue holding equity investments.  No one enters a stop-loss order hoping it gets filled; rather, they hope the stock continues to increase in value.

This type of order allows investors to gain more comfort that losses are limited and profits can be protected, while at the same time continuing to own the stock in the event it increases in value.

We will explain stop-loss orders through two investors, Mr. Cooper who finds they assist him in protecting profits, and Mrs. Davis who uses them to limit losses.

Protecting Profits

Mr. Cooper uses stop-loss orders to protect profits.  He has several stocks in his portfolio of 25 companies where the current market price is significantly higher than what he originally paid.  He would like to protect the profits he has earned but at the same time participate if the stocks continue to increase in value.  We discussed stop-loss orders with him and entered these on a few stocks to protect the profits that he has earned.

Several years ago he purchased 500 shares of ABC Company Ltd at $20 per share (total purchase price $10,000).  ABC is currently at $40 per share; Mr. Cooper still likes the company and feels there is further upside.

One concern we expressed to Mr. Cooper is that the shares in ABC had become overweight in his portfolio.  To reduce risk, and protect profits at the same time, we mapped out a plan using two stop-loss orders.

For ABC we recommended he set a stop-loss order at 10 per cent below where the stock is currently trading on 250 shares, or $36 per share.  For the other 250 shares, we recommended setting a stop-loss order at 20 per cent below where the stock is currently trading, or $32 per shares.

By setting the first stop-loss order closer to the market price (only 10 per cent) it has a higher likelihood of being filled.  If filled, a portion of the profits would be locked-in and at the same time he would be reducing his overall portfolio risk.

If the first stop-loss order is filled, then the remaining number of shares will be closer to the recommended position size for Mr. Cooper.

The second stop-loss order remains in place for the period of time selected.  Of course, the shares of ABC could continue to increase and neither is filled.  If ABC continues to increase in value we would recommend Mr. Cooper increase his stop-loss prices accordingly to keep the same 10 and 20 per cent ranges.

Limit Losses

Mrs. Davis uses stop-loss sell orders to limit the risk of losses.  Most of her portfolio is corporate bonds, but has recently purchased several high quality dividend paying common shares.  Prior to purchasing these investments she mentioned that the maximum she would be willing to lose on her equity holdings is 20 per cent on any one investment.   We reviewed stop-loss orders with her and entered these on every investment she purchased to limit the downside.

As an example, she purchased 200 shares of DEF Company Ltd. for $40 per share (total purchase price $8,000).  At the same time we entered a stop-loss order to DEF if the share price drops to $32 per share.  If the share price increases in value we discussed increasing the stop price on a quarterly basis during our meetings.

Mrs. Davis does not want her stop prices to ever be decreased, even if the market value declines after rising.  After the first quarter the share price has increased to $42 and the stop-loss order increased to $33.50.  Stop-loss orders allow Mrs. Davis to participate in the equity market knowing that potential losses are limited.

Other Important Points

It is important to note that a stop-loss order to sell GHI Company Ltd at $45 per share does not guarantee that the minimum price is $45.  If the price drops to $45 or below, the order converts to a market sell order, which may be different then the stop-loss price.  Most companies releasing important information do so after market trading hours.

If GHI has a current market price of $47, but releases negative news after market hours it is possible that the stock will begin trading the next business day at a significantly lower market price, say $42.  In this case, the shares would have been sold at $42, rather than $45.

The challenge every investor has with stop-loss orders focuses around timing and at what price to put the stop-loss at.   It is important to balance your intention to sell the position with a price that allows for a reasonable level of fluctuation.

The term “whipsawed” is a frustrating situation where a stock declines temporarily to the stop-loss price, even within one trading day, and then increases above the stop-loss price.

Stop-loss orders should not be used for thinly traded positions.  Thinly traded positions refer to those equities having low trading volumes.  When volumes are low, price fluctuations can be magnified.  Stop-loss orders are generally set for a period of up to three months.

This type of order may also be useful if you are planning an extended holiday and want to protect some profits or limit losses while you are away.  These orders may be changed or cancelled if they have not been filled.

We encourage anyone considering stop-loss orders to monitor outstanding orders carefully, especially around earnings announcements and press release dates.  Prior to entering any stop-loss orders you should estimate the tax consequence if filled.