The stock market fluctuates all the time, it is just the nature of the beast, and so stock prices sometimes can take a plummet because world events or negative news of the company. Let's picture a scenario where you own shares in a particular company. These shares start to fall and you want to put in an order to sell right away to limit your losses. Before you can even do anything about it the market has closed, and the loss on your investment is larger than you have expected. Thankfully, there are ways to avoid this, and this is called a stop loss trade.
This type of trade is an transaction that instructs the broker to sell your stock if it drops to a certain price. This is very useful because if the market does drop, you can limit your losses by the setting a price in advance to sell it at. This type of order is particularly useful for investors that trade in more speculative investments, since the stop loss acts like an insurance against unexpected market stock drops.
To understand the mechanics of this trade, let’s use an example:
Ford was purchased for $25 and you want to protect yourself by limiting your losses by 20%. So what happens is you execute a stop loss order for $20 ($25 x 0.80 = $20). As long as Ford trades above $20, the sell order will not be executed. But once the order does drop to $20 and below, the sell instruction is triggered and the shares are sold at the then market price.
If you have your own discount brokerage account, the stop loss order is available and generally is right below the buy/ sell order. Below is a picture of what my discount brokerage screen looks like when I make trades:
Keep in mind though that my trade screen may differ from what you have, but the general trades and order you can select should be similar. In my trading screen the stop loss order are divided into two parts (in the red square above), the "Stop:" price and the "Stop Limit" price. The "Stop" price is the price when the trade will be triggered. The "Stop Limit" price is the price that the shares will be sold at.
Stop Loss Order Disadvantages
If the stock you purchased has large fluctuations there is a chance the stock may fall below your stock loss price, triggering the sell, but then the price could jump back up again. This would make you miss out on the rally.
A suggestion I have is if you do plan to use this order, check up on it monthly or every 2 months. If the stock has been steadily rising, you may want to adjust it to solidify the unrealized gains you made.
The stop loss order is perfect if you do not have the time to research on your investment. In a previous article, I had written about the 3 Signs It May Be Time to Divest Your Stocks. In the link, I had provided some quick tools to help provide insight in the companies you invest in. However, this article is quite technical to understand, and if it is, then go with just the stop loss orders in your investments.
Investors invest in the hopes that companies will go up over time. But there is always the risk that investments do not go as planned or the stock’s business strategy just doesn’t reflect its market realities. This is all part of learning from our mistakes, but let’s ensure the mistake isn’t overly expensive by applying a stop loss order.
Do you think your portfolio can benefit from using a stop loss order? Let me know.