Trading with Stop Loss Orders
A market order is not the only type of stock trade available. Another common type of order is a “Stop-Loss.” With a stop-loss, the trader instructs their broker to sell a particular stock as a market order if its’ share price falls below a particular value.
Say for instance you own 100 shares of Washington Mutual (WM), which is currently trading at $11.89. You are afraid that some negative news may be coming out and would like to minimize your losses. In order to do this, you set a stop-loss trade to sell at $10/share. If the price of WM falls below $10/share, the stop-loss will trigger a market order for the shares. This will help to ensure that you liquidate your positions and avoid a major downturn.
While stop-loss orders may seem like a worry free solution, Jonathan Burton of Marketwatch.com has a differing opinion. He feels that they really aren’t all they are cracked up to be. While they do offer great downside protection, they can come back to haunt you as well. Going back to the Washington Mutual example, let’s say that WM drops to $9.85/share. Suddenly a market order for your shares take place and you no longer hold WM. Now let’s imagine that after it hits $9.85/share the stock bounces back up to $12/share over the next few days. Now you are stuck having sold out at $9.85, while you could still be holding on at $12/share.
According to the article, “Stop-loss orders are geared to traders and investment professionals who buy and sell shares frequently. They might lose 10% in a stock one day and make 25% the next. The stop-loss is a way to avoid a beating if they’re wrong.” Short term traders can easily just walk away from a stock and move on to the next. Longer term traders tend to have more of an emotional attachment to the company. This can be in part because of the amount of time spent trying to find the company, or financial roller coaster that the company has put them through. Long term traders are more likely to keep watching the stock after they sell and beat themselves up mentally saying, “if only I hadn’t…”
In an interesting statement, the article points out that “things often rebound very quickly and it’s very hard to recapture the stock at a good cost basis. It’s almost like ensuring that you will sell in irrational market panics.” The market is not always right and is often subject to major corrections in times of volatility.
Jonathan does suggest an alternative to the stop-loss method. “The trailing stop is a stop-loss order that you adjust upward as a stock moves higher. If a stock rises 10%, raise your stop by 10% and so protect your profits. You still run the risk of being sold out earlier than you might like, but at least you’ll have something to show for it.”
As a final bit of wisdom, Jonathan states that “if you’re a long-term investor it doesn’t make a lot of sense (to use a stop loss), and if you’re a short-term trader you’d be better off watching the stock. Long-term investors should simply monitor the stock’s fundamentals.”
Tags: stock, stop loss, trading, trailing stop loss, washington mutual, wm