Stop loss orders

With the increasing sophistication of share trading, many investors now make use of something known as a ‘stop-loss order.’

What is a Stop-loss Order?

A stop-loss order is one of the class of orders known as ‘conditional orders.’ As that name suggests, a conditional order is one that is only placed into the market when some predetermined condition has been met.

A stop-loss order is an order to sell a shareholding. The sale order is only placed into the market when the market price for a specific security falls below the predetermined trigger point for the order.

For example, suppose I buy 100 shares in company X, each valued at $10. I then visit my online trading screen and place a conditional order to sell all of my shares if the market drops to $9.50. This order then stays ‘within the system’ until the time that I nominate the expiration of the conditional order.

If the price does not drop to $9.50, then the shares will not be sold. But if the price does drop to this point, then my shareholding will be sold automatically.

What Are Stop-Loss Orders Designed to do?

The idea of a stop-loss order is to minimize the extent to which an investor is exposed to falling share prices. The strategy works well within a context of ‘letting profits run and cutting losses.’ This is because the investor places a ‘floor’ below which the value of his or her shareholding should not fall. If the price of a security reaches the trigger point, the security is sold and the investor’s portfolio moves back to the comparative safe haven of a cash holding.

In the example above, the maximum loss that the investor would face is 5% plus brokerage. This is because the investor will automatically sell shares should they reach that trigger point. Therefore, by using a stop-loss order an investor can create a situation in which downside risk is managed.

How to Place a Stop-Loss Order

Stop-loss orders are easy to place. Any reputable online brokerage will make the facility available, as of course will full service brokers. Typically, an additional brokerage of around 20% (of the standard brokerage fee, not the value of the holding) is charged for a conditional order.

When making a stop-loss order, the investor is able to nominate the price at which the order will be triggered and the period during which the order will remain current. Typically, brokers only charge a fee for those orders that are actually implemented.

Notification

Most brokers will offer an immediate e-mail notification when ever a conditional order is implemented. This is very important, as it may be the first point at which the investor becomes aware of a sharp drop in the price of the security.

The notification gives the investor an opportunity to re-examine the underlying company and its prospects. Bear in mind that a falling share price can actually be good news is that somebody who is following a company. That individual may, on further examination, decide that the lower share price represents an improved buying situation. In such a case, the investor would decide to once again make an investment in that company.

If the reinvestment occurs at the same price as the price at which the conditional order took effect, then the investor will have lost the brokerage on the transaction. Many investors feel that this is a small price to pay for the ability to limit their exposure to loss on an individual shareholding.

If the reinvestment occurs at a lower price than the price at which the conditional order took effect, then the investor will be able to purchase a larger holding in that company for the same amount. Given that the investor obviously likes the prospects of the target company, this is of course a good thing.

If the reinvestment occurs at a higher price than the price at which the conditional order took effect, then the investor will have lost on the transaction. Once again, this loss must be looked at in the context of the opportunity that the investor is purchasing by placing the conditional order.

Words of Caution

As with any investing strategy, stop-loss orders are not without their risk. There are various features of which an investor should be aware when making use of a stop-loss order.

Very Sharp Falls

The first such feature is that the stop-loss order will typically only be actioned if the price of a security actually stops at the trigger price for long enough. For example, if a stop-loss order is placed on a security at a price of $9.50, it is possible that, in a quickly falling market, the security may stop at that price for too short a time for the order to be actioned. By the time the order is ready to be actioned, the market price has fallen further. This means that the shareholder will not be able to find a buyer at their trigger price, and the sale will not occur.

It is of course also possible that it quickly falling market, the trigger price may be bypassed altogether. For example, a security that closes at $9.60 on a Tuesday night may open at $9.40 on Wednesday morning. In this case, the investor will be stuck with shares that have fallen below the point at which they wanted to be divested.

Some brokers allow you to 'get around' this problem by actioning the stop loss order when the price reaches or falls below the trigger price. This means that if the price falls so sharply that your trigger price is not settled on, the order will proceed at the lower market price. You need to be aware that this means that your stop loss order may take effect at a lower price than you intended - how low will depend on how fast the price falls and how many other people are trying to sell.

Volatile Securities

The prices of certain securities are inherently volatile. Wide swings can occur in short periods of time. Care must be exercised when placing a stop-loss order on a security such as this. This is because the sharp fall which triggers the order may only be temporary. By the time the investor has realized that their holding has been sold and has focused their attention back on the security, the price may have risen again and all that the conditional order has done is lock in a loss for the investor.

This volatility should be managed by careful selection of the trigger price for the order. For example, if it is known that temporary falls of up to 10% in the market price of a security are common, then the investor should not choose a trigger price that is within 10% of the current market price.

Ex Dividend

In addition, investors need to be aware that the market price for a security will typically fall on the day on which that security goes ‘ex dividend.’ For example, if a share is worth $10 on a Tuesday evening, and on the Wednesday goes ex a $.50 dividend, then it is quite possible that the market price about security will fall to $9.50. Of course, the situation for the shareholder has not changed at all: their assets are still worth $10 (50 cents in cash and the share worth $9.50) but they will have automatically sold shares that they may actually wish to continue holding.

Laziness

Finally, investors need to be aware that conditional orders can lead to laziness. A direct share portfolio must be attended to regularly. Stop-loss orders, as with all conditional orders, can quickly be made redundant.

The situation of a quickly falling share price, which skips the trigger price and bus does not allow the investor time for the conditional order to be implemented, is one example of a stop-loss order being made redundant. However, stop-loss orders can also be made redundant when share prices rise.

For example, suppose an investor purchases a security for $10. They place a stop-loss order at $9.50. They then forget all about the share holding. The price increases to $15, representing a 50% gain for the investor. However, because of the presence of the conditional order the investor has stopped paying attention. The next week, the share price falls to $12. While the investor has still made a 20% gain, they have actually made a 20% loss from the peak of $15.

What the investor should have been doing was revisiting their portfolio periodically and increasing the trigger prices at which their conditional orders had been set. Remember, every day that an investor continues to hold she is in a particular company is a day in which the investor has effectively repurchased their holding in that particular company. Given that the holding has been repurchased, it should also be re-protected by an investor who wishes to make use of conditional orders.