When you buy a stock, you expect its price to rise . . . and you expect to pocket some profits. The truth is, however, that stock prices often head south. Sometimes they even tumble. And if that happens when you don’t expect it, you could lose a bundle. Maybe even your entire investment. All too often, when I talk to supposedly “savvy” investors and hear some tale of how they lost money in the market, I discover that they neglected to take advantage of “stop-loss” orders — easy-to-use investment tools that we’ve talked about more than once.
Briefly, here’s how it works: A “stop-loss order” is an order you place with your broker instructing him to sell a stock that you own at a price below the current market price. Suppose, for example, you have just bought 100 shares of ABC at $50 per share. You decide that you only want to risk $5 per share on this transaction. With that in mind, as soon as you buy the stock, you place a “stop-loss order” at $45. This means that if the price of ABC should drop to $45, your broker will sell your 100 shares at a market price of (or as close as possible to) $45.
The use of a stop-loss order will therefore pre-determine that the most money you can lose on the deal is $5 per share. I suggest you set your stop-loss point somewhere between 10% and 20% below the price you paid for the stock. This is not a hard and fast rule, though. You need to determine just how much you can “afford” to lose on any given stock, bearing in mind that a volatile, relatively low-priced issue might swing 10% one way or the other in just a single trading session.
Brian Hunt, vice president of Investment U and a market strategist, recently analyzed how investor David Ryan won the stock division of the U.S. Investing Championship not once but two times. One of the things Brian discovered is that David used stop-losses on every purchase . . . registering a return of 160% in 1985 and then coming back the next year to register a return of 161%. According to Brian, David Ryan knows what will cause him to sell a stock BEFORE he buys it. That means setting a stop-loss point. “I follow his example and set a stop-loss on every position,” Brian said. You should too.
But placing simple stop-loss orders to minimize your downside is just the beginning of what you can do with this investment tool. I also strongly urge you to use what are known as “trailing stops” to lock in profits as your stock’s price rises. Let’s again assume that you purchased 100 shares of ABC at $50. Let’s further assume that ABC’s price then increased to $60. With a trailing stop, you can protect or lock in a portion of your unrealized profit in the event that ABC’s share price heads south.
To do this, you would cancel the existing stop-loss order at $45 per share and place a new stop-loss order at, say, $55. If the share price declines to $55, your position will be sold out at a gain of $5 per share. If, on the other hand, your stock’s price keeps rising — say, to $70 per share — you could move your trailing stop higher . . . maybe up to the $63 level, locking in a gain of $13 over your purchase price of $50 per share. As the stock keeps going up, you simply move your stop-loss higher and higher . . . as many times as you wish. You can add stop-losses to your stocks with a few simple steps.
If you deal with a full-service broker and want to use stop-loss or trailing stop-loss orders, you simply need to tell your broker to put them into play. There’s no charge for doing so until or unless they’re activated. At that time, obviously enough, you would have to pay the regular broker’s commission fees. If you trade online, it’s up to you to regularly track your stocks and move your trailing stop-loss orders as needed. To repeat my earlier caveat: Make sure you place your stop-loss price far enough below the current market price to compensate for the normal daily volatility of that particular stock. If you don’t, you will find that your positions will be frequently and unexpectedly closed out.
(Ed. Note: Brian Hunt, vice president of Investment U, is also the editor of Microcap Moonshots.)