Understanding and utilizing stop loss orders is a very critical component of your overall portfolio management strategy….Use stop loss orders to protect your profits by taking the emotion out of your trading decisions…[or when you are] on vacation or cannot monitor positions on a daily basis. [Here are the specifics.] Words: 615
Stop Loss Order
A stop loss order is an order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit an investor’s loss…With a stop-loss order for a long position, a market order to sell is triggered when the stock trades below a certain price, and it will be sold at the next available price. This type of order works well if the stock or market is declining in an orderly manner, but not if the decline is disorderly or sharp.
For example, if you own shares of Silver Wheaton trading at $20, and you want to hedge against a big decline, you could enter a stop-loss order to sell your SLW at $16. This type of stop-loss order is also called a sell-stop order. If SLW trades below $16, your stop-loss order is triggered and converts into a market order to sell SLW at the next available price. If the next price if $15.90, your SLW shares would be sold at $15.90.
I prefer to use stop-limit orders, which seek to sell the stock at a specified limit price – rather than the market price – once a specified price level is breached. Although stop-limit orders will also not work if the stock is halted down or has a price gap, the risk of the long position being sold at a significantly lower price than the specified stop price is lower than with a stop-market order.
Trailing Stop Loss Order
The type of stop order that I use the most is the trailing stop loss. The trailing stop loss order is a stop order that can be set at a defined percentage away from a security’s market price. It automatically tracks the stock’s price direction and does not have to be manually reset like the fixed stop loss order.
The trailing stop loss order is designed to protect gains by enabling a trade to remain open and continue to profit as long as the price is moving in the right direction, but closing the trade if the price changes direction by a specified percentage. A trailing stop can also specify a dollar amount instead of a percentage. Also known as a “chandelier stop.”
Let’s use Silver Wheaton as an example again and say that we purchased shares at $20. The share price climbs to $30 over the next month, but then dips back to $18 in volatile trading the following month. With a regular stop loss order set at $16 (20% below your purchase price), it would never get executed and you would give back all of your prior gains, plus lose $4 per share.
With a trailing stop loss order set at 20% and shares of SLW at their high of $30, the stop loss order would be automatically adjusted to $24 (20% less than $30). Now when the share price plummets, you will get stopped out at $24 and protect your profits of $4 per share. Better yet, you would not go into the red as the share price continues to fall to $18. This is the beauty in a trailing stop loss order.
I usually set my trailing stop loss orders at 15% for large cap stocks of $1 billion or more and 20% for small cap stocks under $1 billion. The greater the volatility of the stock, the greater percentage that I use. This ensures that I am not stopped out on a quick dip and then miss the rebound…