Risk Management Basics: Using a Stop Loss

Imagine entering a position where your upside potential is infinite while downside risk is limited. Well it exists in every stock using a Stop Loss Order. A Stop Loss Order is an open order to sell any stock held if it falls below a price. As long as the order is not executed it is a free form of insurance.

Ex. John buys 100 Shares of Facebook at $96.95. As John is only comfortable loosing $500 on the trade he places a Stop Loss Order at $91.95. If at any point the stock falls below $91.95 the order will be executed to sell the stock. Alternatively John places a Trailing Stop set at a 10% loss. If the stock drops 10% from a new high it will be sold. This automatically raises the stop if the price of the stock goes higher.

Here are the Pros and Cons of Setting a Stop Loss Order:

Pros:

  1. Risk management

By controlling your losses you remain emotionally disciplined and avoid holding a dog that can singularly drag down your portfolio. Not allowing your trading not be emotionally controlled lets you look simply at the facts of the trade. This can be done while having your own, personal, risk tolerance.

  1. Flexibility

A stop monitors the stock so you don’t have to. That way you can relax on the beach with your martini knowing well that you are protected against downside risk. Furthermore a stop loss can be adjusted when the price of a stock goes up, locking in profits. This gives you piece of mind that your winner will never become a looser.

Cons:

  1. Price Spikes

Price spikes are strong moves in a stock that can occur during a day or even over a few minutes. They cause the price to fall to unjustifiable levels, triggering your stop, before algorithms and traders bring the stock back up. Price spikes are of most concern with illiquid stocks. Large buy or sell order can temporarily drive down price, or algorithms can strategically take out your stop. To avoid this check the daily volume and chart on a stock. As a general tidbit chances are if you have heard from the stock ex. Google, Netflix, Walmart it is a liquid stock, if it is something like Athabasca Creek Mine it probably isn’t.

  1. Setting the Right Stop

Setting the correct stop can sometimes be challenging for even an advanced trader. Too high and you are stopped out on normal volatility, too low and losses can be multiplied. Preferably you can set the stop slightly below price support with enough space to leave for a bit of volatility. This allows the stock a little room to move if it is flirting at support levels.

Normally the first thing I do when I see a stock I like is identify where to set my stop. Then by looking at my entry price I calculate my risk per share (Entry Price-Stop Loss price). I can then buy shares up to my risk tolerance level (say $500 per trade). I either place a stop loss order or if the stock isn’t super liquid I will monitor daily. If it closes below my visual stop loss price I will plan my exit.

Stop losses are an extremely important part of risk management and are an essential tool in managing your portfolio. Just think of all the things you buy insurance for. Heck I had a guy try to sell me insurance on a microwave. If your microwave breaks odds are you will survive, if your portfolio tanks its trouble. Hence taking out free insurance is a smart choice on your most valuable asset.

**When speaking to your advisor

Sometimes advisors are hesitant with the work of constantly maintaining and raising stops. Assuming you are not the advisors top client you are probably not first on their list to call when the stock is in trouble. Thus having a stop-loss gives you protection and a piece of mind that losses are limited and your financial interests are well taken care of.

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