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Don’t Go Down With the Ship, Use Stop Loss Orders

A stop loss order is an order placed with a broker to sell when a certain price is reached. It is designed to limit an investor's loss on a security position and is sometimes called a stop market order. They are particularly useful if you go on vacation or can't check on your stock's price-volume action on a daily basis.

We recommend the stop loss order because first of all, the stop-loss order costs nothing to implement. Your regular trade commission is charged only once the stop-loss price has been reached and the stock must be sold. I don’t recommend you think of it as a free insurance policy, as some people do, because you can’t guarantee that there’ll be a buyer.

Secondly, but most importantly, a stop-loss removes the emotional component from decision making. When your stock drops to your set point … bang, the sell order goes in. It is a good way to make a forced separation no matter how much you’ve fallen in love with your stock. The stop loss will keep you from succumbing to our natural tendency to hold on to a losing stock so we can give it another chance. It also ignores the natural period of delay and procrastination that occurs when you would otherwise be deciding to sell or hold on a downturn. Sidestep those loses before they mount.

Lastly, you shouldn’t use a stop loss if it is inconsistent with your overall strategy. Although this seems like a contradiction, it really isn’t. You should always have a reason for buying a stock and have a place for the stock in your overall strategy. If you are buying a stock for a long period, over 10 years on the premise of value investing, a stop loss order is not for you. Besides, you don’t want to have the stop loss order on the books for that long. But if you are buying for growth, than this is a good play. You don’t want to take three steps back after taking two forward. Use the stop loss to get out after only one step back.

Stop loss orders are not the perfect solution and there are some problems associated with them. However, the upside outweighs the downside. Stocks dip, often for no reason, and you don’t want to have your stop loss set so close that a small dip triggers your stop loss when the stock is just going to bounce back. Furthermore, if the market is weak and volume in a stock is thin, it's possible that traders may drive down the stock's price just low enough to activate your order and poach your shares.

Some people set their stop loss orders at 2% to 3%, 7% to 8%, or even 20%. Find the absolute bottom that you are comfortable with and move up a bit from that to give yourself a small buffer. If the stock gaps below your stop order price, the price you actually get may be lower than your stop loss price. Use this to sell before you are out of your comfort zone.

Here is a good example of how a stop loss would have protected you. Look at the last five years of Lucent (LU):


If you had a stop loss order in place in January of 2000 for 10% off the value, you would have gotten out near the top. You might have been worried when in March it jumped back. And even if you bought LU back, as long as you set another stop loss, you would have been relatively unscathed. If you held on waiting for a recovery, where would you be now? Even after five years.

Take this away: stop-loss orders do not guarantee you'll make money in the stock market. That depends on the investment decisions that you make. Stop orders are just a way of keeping yourself in a profitable trade as long as possible without giving up a significant part of the profits. Who wouldn’t want that?