So how does a Stop-Loss work and why should you be interested?
Let me give you an example: Say you have bought shares (gone long) you can place a sell order that is below the current market price, which will only be triggered if the market price drops to the level, this is called a Stop-Loss. But why would you put an order to sell the stocks you own at a lower price than the stock is currently trading at?
There is one main reason. Emotion.
Emotion is the biggest cause of investment losses for the private investor. This is particularly true if an unrealized profit turns to a loss. Let’s say a stock you own goes up 40%, then along comes a profit warning and it’s down 20% and you think “Oh it will come back. Won’t it? I’m still up 20%” Then the stock continues on a downward trend and falls to your purchasing price. Now all your profit is wiped out. “All that profit gone, it has to come up!” It falls another 20% “Dammit I hate investing” down another 20% “Okay, okay, I’ll keep calm, I’ll sell it when it goes back up and I can break even. Piece of cr*p company!” Down another 20% and what happens? It is called investor capitulation and normally it goes like this. (Fill in the blanks in the following sentence)
“ ______ why did I listen to my ________ father-in-law? That good for nothing _______. He’s the one who recommended the __________ _________ __________ ________ stock. I knew it was a bad ______ idea. The market is ______ rigged against a small ______ of an investor like me. Each and every time, those _____ guys in the ______ investment banks just bend us little guys over, lube our _____ up and stick it to us. That’s it, last _______ time for me. No Sirreee, no more BOHICA for me, I ain’t their Ladieboy no more. I’m going to call my ______ broker, who’s a complete ______ idiot, why didn’t he tell me to sell at the top? _______ _________ he’s supposed to be a _______ ______ pro. ______ him. I’m ______ selling that _____ now!”
And then the stock is sold at a hefty loss.
See what I mean? Pretty emotional stuff this capitulation business.
If your stop is hit, then it might sting for a bit, but you are no longer sitting on a losing position, you are ready to sit down an evaluate the thing again (I normally recommend a few stiff drinks and to come back to it in a week or two, or until you aren’t peeved off about it anymore)
The thing so many people seem to misunderstand about investing is that you will inevitably lose money. Not every individual stock you invest in will be profitable.
A portfolio of investments is like war. It is made up of several different battles in several different locations, fought with a multitude of different weapons. The fact is that some of those battles will be lost and a great general will know when to retreat and regroup. That is what putting a Stop-Loss is all about.
So how far away should you place a Stop-Loss? (Perhaps I should save that for another blog post) Where you place it is a matter for you to figure out. Some place it based on volatility, some on moving averages and some on a percentages. As a rule of thumb it should be placed far enough so that the normal daily movements won’t hit the stop, but a short shock or change in trend will hit it.
This is important to remember as well: Your Stop-Losses should be trailing. What this means is that you check your stock once a week, and if the stock has moved up, you adjust the Stop-Loss order by the same amount in the direction of the upward move. Never move your stop down. Always, always, always only move it in the direction of the profitable movement of the trade.
Just to give you an idea of the importance of the Stop-Loss. I remember several years ago a meeting with a very successful stock trader who had a track record going back a decade. In general the number of winning trades to losing trades was very close to 50%. The majority of his profitable years the amount of losing trades was actually higher than the amount of winning trades. So how was that possible? Simple; the use of Stop-Losses, his losses were always cut short while his winning trades were allowed to run.
Pros do it, private investors don’t. Log into your account now and set your Stop-Losses. If your broker or banker doesn’t facilitate Stop-Losses then change broker/banker. Now!
Be honest: Have you ever used a Stop-Loss?