Understanding Stop-Loss Orders

I’m writing this hot off the heels of what I’ll call “GameStop Mania.” As a quick refresher and as succinctly as I can put it: GameStop, the beleaguered video game, consumer electronic and collectibles retailer, had its stock price surge due to a massive short squeeze driven by message board fervor on the website Reddit.

Speculators and day trading ruled the day, leading some profits to be measured in percents ranging from the hundreds to the thousands. The herd mentality is real and leads some investors to jump into a hot new stock without doing their full due diligence. In these circumstances, timing can mean everything and jumping in without a clearly defined exit strategy can lead to great losses.

Financial media was reporting on the “gains” in these heavily “bet on” stocks. But returns are only one side of the equation — the other being risk. When speculating, it’s risk that must be the focus of a trader. The obvious question is: How can a trader/speculator manage risk?

The key is understanding and limiting the downside you’re willing to accept. What level would the price on an investment need to drop before you reevaluate your thesis? Investors do not buy a stock expecting to lose money, however, that risk can be significant, particularly when a trader’s time horizon is short.

Understanding the power of the stop-loss order is an invaluable tool for those looking to invest.

A stop-loss will limit the downside to your investment. For example: If you would like to limit your downside to a 5% loss, then set your stop-loss order to 5% below your purchase price.

A stop-loss order can be set at your broker and stay in effect until you cancel.

Adjusting for a Dynamic Stop-Loss Order

This may sound like a passive strategy to not lose too much money, however, it’s much more than that. The stop-loss order should be considered dynamic.

If the stock you purchase doubles in price, the original stop-loss you set is likely inadequate after the appreciation. Stop-losses should be monitored and adjusted accordingly. Perhaps as an investment grows, you’re willing to accept more downside as a relative percentage than you were upon your initial purchase. Either way, as your investment increases, your stop-loss should increase with it.

Another way to make a stop-loss dynamic is to use a “moving average.” Investing in the markets successfully demands that you understand moving averages, which are what they sound like, averages of historical prices for a stock.

Moving averages represent the trend of the stock/investment and because of this, moving averages can make great targets for stop-losses. A stop-loss order with your broker may be tough to enter, so it’s up to the investor to monitor and execute the stop-loss in a disciplined and timely manner.

Discipline is what makes traders and investors successful. It can be the difference between watching your speculative trade go from $40 to $400 and back to $40, leaving you with zero profit, or languishing with a “value trap” because you’re unwilling to take a loss.

Use stop-loss orders as a way to thoughtfully identify the risk you’re willing to take and inject more discipline into your investment process. After all: “Nobody ever went broke taking a profit.”