…[The stock market can be very volatile so it is important to use stop-loss orders to protect your profits. Here’s why and how best to do so.]
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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 and can be effective at taking the emotion out of trading decisions. These orders are especially handy when one is on vacation or cannot monitor positions on a daily basis.
With a stop-loss order (also called a sell-stop order) for a long position, a market order to sell is triggered when the stock trades below a…[price specified by you], 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.
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.
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 (also known as a “chandelier stop”) 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.
Let’s…say that we purchased shares of a company at $40 and the share price climbed to $60 over the next month but then dipped back to $40 in volatile trading the following month.
- With a regular stop-loss order set at $32 (20% below your purchase price), it would never get executed and you would give back all of your recent gains.
- With a trailing stop-loss order set at 20% and shares at their high of $60, the stop-loss order would be automatically adjusted to $48 (20% less than $60). Now when the share price plummets back to $40, you will get stopped out at $48 and protect your profits of $8 per share.
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 the percentage that I use. This ensures that I am not stopped out on a quick dip and then miss the rebound. There are some cases, however, where I prefer to monitor my positions manually and not rely on stop-loss orders but that depends on various factors.
As you can see, understanding and utilizing stop-loss orders is a very critical component of your risk management strategy…
Editor’s Note: The above excerpts from the original article* have been edited ([ ]) and abridged (…) for the sake of clarity and brevity. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.