Every investor and trader knows the feeling: You bought a stock, but then it dropped. You held on, hoping for a rebound that would at least get you back to even.
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Emotional trading, which includes holding for too long, can be avoided with a stop-loss order. Here’s what you need to know about stop-loss orders and their most effective use in stock trades:
— What is a stop-loss order?
— How a stop-loss order works.
— Using a stop-loss order to lock in gains.
— Advantages of a stop-loss order.
— When a stop-loss order is not the best action.
— Using a mental stop-loss.
— High-net-worth investors benefit from a stop-loss.
What Is a Stop-Loss Order?
A stop-loss order is a buy or sell order on a stock at a specific price that either prevents a loss or locks in a gain, according to Stephen Henn, an adjunct professor of economics at Sacred Heart University in Fairfield, Connecticut. “It is usually a strategy to minimize risk or cash in profits,” he says.
“Importantly, you can put in a stop-loss order for a portion of your position, so an investor can adjust their risk,” he adds. “Since stop-loss orders are automatic, it is more of a strategy for investors focused on short-term portfolio performance.”
A stop-loss order protects your portfolio from significant downturns and reduces emotional decision-making. However, it may also trigger a sale during temporary market dips, resulting in unnecessary losses.
How a Stop-Loss Order Works
If you buy a stock and want to avoid big losses, you can determine a level at which you’ll sell, no questions asked. Setting a stop-loss price helps protect your investment by automatically selling the asset if its price drops to a predetermined level. This can prevent significant losses by taking panic out of the decision-making process.
For example, say you bought a share of Microsoft Corp. (ticker: MSFT) at $419.70 on April 10, 2024. You weren’t willing to just buy and hold if the stock dropped sharply. You decided that you would cut losses if the stock dropped 7%, to $390.32.
The stock began struggling soon after you bought it, and on April 25, fell to the level where you’d set your stop loss. Rather than deliberating about the likelihood of a rebound, you just cut your losses and preserved your capital to invest another day.
All this was done automatically, as you entered the stop-loss order with your brokerage at the time you purchased the Microsoft share.
Using a Stop-Loss Order to Lock In Gains
Another use of the stop-loss order is to protect paper gains, and turn them into real money.
Using the same example of a Microsoft purchase at $419.70 on April 10, say you wanted to sell after the stock gained 7%. In that case, you set your stop-loss for $449.08. On June 17, when the stock price reached that level, it triggered your stop-loss, and you sold Microsoft for a 7% gain.
A word of caution: Be sure to proceed slowly and carefully, and double-check your math when entering your order. Inputting the correct stop-loss price and other order details ensures your order will execute as you intended.
Reviewing your order before confirming will help catch any errors or changes that you may need to make.
Advantages of a Stop-Loss Order
If you’re not comfortable losing money in the market, or you just want a strategy that protects your capital, you may benefit from placing stop-loss orders.
“When markets are volatile, which often happens in crisis or political unrest, there is uncertainty,” says Michele Paiva, a therapist and financial educator who owns The Finance Therapist in Downingtown, Pennsylvania.
Anyone can benefit from placing a stop-loss order during times of uncertainty, she says, but it can be especially advantageous for newer investors.
“Most people can’t monitor the stock market all day and chart it day after day, so a stop-loss is a way to manage risk,” she says.
When a Stop-Loss Order Is Not the Best Action
If you’re investing your retirement portfolio strategically for the long haul, you want to rebalance at certain intervals, but trading too frequently may be at cross-purposes with your goals.
Long-term investors may find that frequent stop-loss triggers disrupt their investment strategy.
“If you are a long-term or very seasoned investor, you might not want to use stop-loss because you might not want to sell every time the market dips,” says Paiva.
For example, market veterans with a high risk tolerance may not be sweating every time the market moves. In those cases, a stop-loss order may not make sense.
“If you have a lower risk tolerance, meaning you can’t afford to lose your investment as easily, then you do want to have that parachute or harness attached to your money,” she says.
Using a Mental Stop-Loss
Some traders don’t enter a stop-loss order when they buy a stock, opting instead to manually track the price and sell if it sinks to a predetermined low or rises to a predetermined high. That’s called a “mental stop-loss.”
Unlike formal stop-loss orders, a mental stop-loss relies on the investor’s discipline and market monitoring.
While a few traders and investors may have the discipline to execute on a mental stop-loss, many others will find it only leads to emotional trading.
“Mental stops are more for investors who are seasoned, and prefer a more hands-on approach,” says Paiva. However, she adds that money is emotional, and traders who are newer to the game may not want to dive too far into the process by themselves. Paiva also suggests that newer investors may benefit from working with a licensed professional to help them develop and stick to strategies.
High-Net-Worth Investors Benefit from a Stop-Loss
From her viewpoint as a financial therapist, Paiva says using a stop-loss is valuable even for high-net-worth investors, as it helps control risk, offers some emotional protection and facilitates long-term planning.
“It mitigates anxiety and stress by setting clear boundaries, which is comforting and helps build financial confidence while helping the investor to observe the market,” she says.
“It also encourages discipline; so those who might be prone to overspending or high-risk investing when they have a low-risk budget … will take proactive steps in protecting investments while enhancing investment savvy,” Paiva adds.
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What Is a Stop-Loss Order, and Should You Use It for Trades? originally appeared on usnews.com
