Stop Loss Orders - A Winning Market Tool
There are probably as many strategies for trading stocks as there are companies listed on the major exchanges. They range from fundamental techniques to technical analysis and to exotic and psychic phenomenon. And there is always someone who will swear that any given strategy works.
It is not our intent to sit in judgment on the merits of any single strategy or technique. You the investor will have to take responsibility for making such choices. However, what we do offer are suggestions and techniques to help you navigate the investment minefield, and once you have made a selection, how to protect yourself and your investment.
If you are looking for love there are a multitude of romance chat lines to satisfy every taste. Don't fall in love with a stock. Failure to heed this can prove as expensive and traumatic as the human kind. There comes a time when a relationship is best broken off. There is always another opportunity waiting in the wings.
The problem of course is that making such a decision in the heat of the moment is not easy. There will always be the doubt whether more patience is needed. We believe if we give it another chance, it will come around. Or we decide to take definite action tomorrow, but tomorrow never comes. Often we use another delaying ploy. We seek advice from friends and relatives, but hear only what we want to. And in the meantime, the losses mount.
The only way to avoid this dilemma is to remove the decision making from any emotional influences. It must be automatic, triggered by predetermined rules or guidelines that at times might seem to be a bit ruthless. Clean and surgical. No second guessing.
How does one achieve this on a daily basis? By employing the discipline of stop-loss orders as a key investment strategy. What is a stop-loss order?
It is an instruction to your broker to sell out your position in a given investment at a predetermined threshold price if the market goes against you.
If you purchase a stock at $50 a share with a price objective of $70, you should consider a stop-loss order at around $47 in the event something went wrong, so you aren't left sitting with even larger losses to overcome. Conversely, if the shares move up in price, you keep raising the stop out point. If the price advances to $60, your stop will likely be raised to the area of $57. Now you are also locking in profit.
There are no hard and fast rules for where stops are placed. But there are "rules of thumb" that professionals advise. In most cases, the spread between the market price and stop out point should be proportional to the price of the investment. The higher the price of the shares, the larger the spread. For stocks selling at $50 and above a $3 to $4 spread may be appropriate, while for shares selling at $10 and less the stop might be set at $1 below the purchase price.
Some allowance for price volatility might be appropriate in certain instances. A stock that has a history of wide swings over short period of time may warrant a wider spread, but this requires extra care to ensure that prudence is not confused with indecision.
How often have we, or friends, personally experienced, investments that were "guaranteed winners?" Ten dollar companies that were definitely going to double or triple within 12 months, but alas are now at $2, still poised for greatness, and we still hold them. Why? Because we just could not make the decision to sell against all the hype we want to believe. Had there been a stop-loss discipline, the decision would have been made for us.
Remember, getting stopped out of an investment does not preclude one from buying the shares back at a lower price if the situation is still believed to have merit. If you decide to re-buy the stock that was sold via the stop loss order, wait at least 31 days in a taxable account to avoid the "wash-sale" rule, which has to do with establishing the cost basis for gains and losses (especially losses). You might be disappointed if the stock you just sold almost immediately moves back up sharply. If that happens, consider it one of the rare occasions where lost opportunity might cost less than lost money if the stock continued to go down after your sale.
Should one of your companies declare bankruptcy or change their trading symbol (e.g. they were delisted from the New York Stock Exchange) the stop loss orders are automatically canceled and will not protect against a drop in value. Stop loss orders work well in "normal" market conditions. It's not a perfect financial tool, just a very good one.
Stop loss orders should be viewed in the same light as an insurance policy on one's home. You hope you never need to use it, but if something happens it is good to know you have the protection. And you do not have to pay a premium.
As an astute stock market pundit once noted: Bulls can make money in the market and bears can make money too, but pigs never do. To which we add, ostriches probably also can't. You have to be able to stand up and make the move.
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