Stop-loss orders: portfolio protection or investor trap? http://www.thestar.com/business/personal_finance/2011/02/18/stoploss_orders_portfolio_protection_or_investor_trap.html
Stop-loss orders: portfolio protection or investor trap?
Many small investors don't fully understand how stop-loss orders work.
Aaron Harris for the Toronto Star
Paul Marshman has learned some lessons from his use of stop-loss orders: They don't always work as expected.
It was the summer of 2008, and everything was looking fine. I had a small portfolio of stocks and funds, all with sound fundamentals and good long-term prospects. The future was bright. Then the crash hit.
Like thousands of other investors, I watched in disbelief as my shares took a sharp drop, then continued down in a death spiral that left some of them selling for less than half of what I’d paid.
I resisted selling, and ultimately recouped my losses as the markets recovered.
But I — and many others — could have avoided much of the pain by using a basic trading tool called a stop-loss order.
Stop-losses are available to every investor, and they’re simple enough for even a beginner to use.
You enter a “sell on stop” order on a stock you own, and choose a price at which you want it executed. If the market turns against you and the stock falls to your stop price, the order is triggered and it’s sold before the damage gets too great. (This is called getting “stopped out”.)
Stops can be a valuable tool for self-directed investors who don’t have brokers to watch their portfolios, says Bob Grant, managing director and head of the online brokerage at Scotiabank.
“They can help you become a better and smarter investor,” he says. “They help you crystallize your gains and make money.”
Sounds good. But for such an essential tool, stop-losses seem to elicit an astounding amount of controversy.
Look through the investing blogosphere and you’ll find a whole spectrum of opinions, from those who consider them free insurance to those who call them a “guaranteed loss order” and a trap for the gullible.
Why the controversy? It’s mostly about the way stop-losses work, and what can happen if things go wrong. That’s a subject many small investors — even those who use stops — don’t fully understand.
“If I put in a stop order at $10, when the price hits $10, it becomes a market order,” explains Cesar Rainusso, vice-president of strategy and product development at BMO Investorline. “But that doesn’t guarantee I’ll get $10.”
That’s because your sell order will be filled at market price, which means whatever it will bring at the moment. But the stock may have fallen past your stop price too quickly — in fact, it may never have traded at that exact price — so you may get substantially less.
This can happen in a volatile market, or even overnight, as I learned first-hand last year. I entered a stop-loss order on a gold stock and went to bed feeling protected from any nasty surprises.
Wrong. I woke up the next morning to find that bad news had popped up after the markets closed and the stock had opened well down from its closing price.
My stop was triggered and my stock was sold at the opening price — below the price I specified.
Things can go even worse if the markets are hit by a violent downdraft. American investors took big losses last May during the famous Flash Crash, when the U.S. markets took a huge, sudden plunge before quickly rebounding. Stops were triggered as the markets went into freefall, then filled at bargain-basement prices.
That kind of damage can be avoided, says Rainusso, by using a stop limit order when you put on your stop-loss. That specifies a minimum price at which you’ll sell, so you won’t get an unrealistically low sale. Problem is, if the stock keeps going down, you’re stuck with it, as if you hadn’t put on a stop at all.
So, is it worth using stop-losses? It depends on what kind of trader you are and what strategy you’re using, says Grant.
Long-term investors who rely mostly on dividends and gradual price gains may find them of little use, he says. They can ride out the market’s ups and downs. And investors who trade every day typically spend hours at their computer screen tracking the markets’ every move. They can hit the sell button themselves.
But for regular investors who trade frequently, using stops can be worthwhile, Grant says. “It’s for people who want to be active but can’t watch their stocks all day.”
The experts agree that if you do use stops, it should be within some kind of overall strategy, and with an understanding of how each stock is trading. That’s essential to putting the stop at the right price so you don’t get stopped out if the stock has a bad day, leaving you out in the cold as it turns around and heads back up.
“Every stock has a natural fluctuation in its price,” says Grant. “The investor needs to understand that and put the stop in below that natural fluctuation.”
In fact, setting your stop price is an art as much as a science. Some traders decide how much money they’re willing to lose on the trade, or how much profit they want. Others determine a maximum allowable loss based on a percentage of the current price, or a percentage of their overall portfolio.
Then there are investors who use the stock’s technical support levels to set their stops. This takes some education in spotting stock trends by studying price charts.
Many traders also choose to use trailing stops, which set a stop price at a chosen percentage — say, 10 per cent — below the current price. As the stock rises, so does the stop price, and if the stock peaks and falls, you get most of the profit. In essence, you guarantee your gain while letting the stock run up.
Independent stock market analyst Bill Carrigan is among those who feel the risks of using stops outweigh the benefits. But, he says, you can get the same benefit without the risks by using “mental stops.”
“If you buy a stock at $13, you decide, ‘If it goes below $11.50, I’ll sell.’ “
That may expose you to some risk in a volatile market, but Carrigan says the damage from a one-day market loss is unlikely to be too serious, especially if you invest in large companies such as Canadian banks. “I’ve never seen a portfolio destroyed in one day,” he says.
Rainusso says stop-losses can be a valuable way to lock in a profit or prevent a loss, as long as you use them correctly and understand the risks involved.
Despite their faults, they’re a good way to take some of the emotion out of trading, preventing the paralysis that leaves investors unable to sell as their stocks fall lower and lower, the experts point out.
“It’s easy to get into a position, but it’s hard to get out,” says Grant.
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