Investing is a percentage game. The lower you can buy a stock and the higher you can sell, then the more money can be gained. But in reality finding the exact bottom or the exact top of a stock is impossible, and most investors will tell you when to sell is the most difficult decision. The key is to use charts to buy a stock near its 52-week low and then firmly decide when you are going to sell (or buy and hold). Using Stop Loss and Limit orders helps you achieve these goals, and protects you from downside risk. Whether you are an active trader, or a buy-and-hold dividend collector, Stop Losses have an important place in your investment strategy.
Buy with a Limit Order
When you buy a stock never buy at market price, especially if a stock has gained a lot of attention in the media. There are too many considerations during the trading day. For example, if you wanted to buy Potash Corp. on Aug.17th 2010, unaware that there was take-over bid looming by BHP, you could have ended up buying the stock at its take-over high of $147 instead of $117! In order to protect yourself when buying a stock, always use Buy with a Limit Order (an order to a broker to buy a specified quantity of a security at or below a specified price). So the Limit is the maximum price you will pay for buying the stock.
Sell with a Limit Order
If you are buying a stock that consistently trades within an established sideways pattern, consider placing a Sell with Limit Order (an order to a broker to sell a specified quantity of a security, at or above a specified price). This is best used when the stock price is increasing, and you can set the order for 30 days or Good Till Cancelled (GTC). Once your stock reaches that price or above, it will automatically sell at the Limit Price or higher. For example if you are buying a stock like EnCana (ECA-T) that trades between $28 and $32 per share, consider placing a Sell with Limit Order at $32. You know ahead of time that your return on the stock will be $4 or 14% return of investment. Of course, you do miss the potential upside breakout, but you do know exactly what return you will get on that particular stock. Selling with Limit Orders takes the emotional equation out of investing, and forces you to take profits. The problem with this type of order however, is you have no downside protection – hence using a Stop Loss Order (see below) is a much better trading tool.
Sell with a Stop Loss Order
A Stop Loss Order (Stop Order) is an order to sell a specified quantity of a security, for which the specified Stop Price is equal to or below the current market price. You select Sell on Stop with your broker, and then set the Stop Price at what price you want to sell your shares. For example if you own Pengrowth Energy Trust (PGF.UN-T), and you think that $12 is the support level you want to sell, then you would place a Sell On Stop with a Price of $12. This helps to protect you against downside protection, but allows you to keep the stock while it rises in value. It’s like buying cheap insurance for your stock investment.
So with a Stop Loss Order you get the benefit of hanging onto a rising stock, but with the added protection of selling if it starts to decline. A Stop Loss Order is also useful when you have just purchased a stock, and you are unsure of its direction. A Stop Loss order can also help you from hanging onto a losing stock, by forcing you to sell sooner than later.
However, a Stop Loss Order can have a double edged sword. If you set your Stop too close to the market price you could end up selling early on a false downward breakout or minor correction. Secondly, any value between $0 and the Stop Price is a sell. So the stock could drop 50% in value and you could end up selling half your investment. That’s why using a Stop Loss Limit Order is a better option than a Stop Loss Order.
One important note is that with most discount brokers (such as TD Waterhouse), you must have a minimum 100 shares (or more with penny stocks) to execute a Stop Loss Order. So if you trade in odd lots, you may not be able to use this type of order. In this case pre-determine your maximum loss (by percentage or charts) and sell if your stock goes below that price. Hanging onto a losing stock and hoping for a rebound is more often than not a bigger loss!
Sell with a Stop Loss Limit Order
A Stop Loss Limit Order is an order sell a certain quantity of a security at a specified Stop Price or lower, but only if the share price is above a specified Limit Price. In other words using the example of Pengrowth Energy (PGF.UN-T) above, you could set a Stop Loss Order with a Stop Price of $12, but also with an additional Stop Limit of $11. This means you will only sell your shares if the price of the stock falls below $12, but is also above $11. The advantage of a Stop Loss Limit Order is if the price falls too sharply you don’t sell. This is an advantage if you are holding a stock and you only want to take profit within a certain price range, else buy and hold.
Using a Trailing Stop Loss
The best of all worlds is the Trailing Stop Loss. This is a Stop Order in which the Stop Price is set at a fixed percentage below the market price. If the stock price rises, the stop loss price rises proportionately. But if the stock price falls, the Stop Price remains the same. A Trailing Stop Loss allows for maximum possible gains on a rising stock, while keeping the added protection from downside risk. The Trailing Stop Loss is only available to active traders, day traders, and with more expensive trading platforms. However with a bit of time you can manually revise your Stop Loss Orders on a weekly basis.
Stop Loss versus Buy and Hold
Much evidence points to the fact that long term buy and hold investors, and index investors, have higher returns than investors who trade frequently. However many buy and hold investors will hold onto a winning stock, and fail to materialize their profits as the stock declines from a peak. Buy and Hold investors should also consider using Stop Loss Orders to protect their investment capital. We only have to look back at the market crash of 2008 to realize how quickly a portfolio of winning stocks can plummet to half its value. However, investors in 2008 who kept Stop Loss Orders or Trailing Stop Losses on their stocks won big time. They were able to prevent the huge decline in their portfolios, sell early in the bear market cycle, and buy back the stocks that had fallen in price.
This is the part of the website where I tell you I am not a professional financial advisor or an investment dealer. This website does not offer professional or financial advice, and is intended to provide general information only. I am not responsible for the investment decisions you make. You should consult with a professional financial advisor before making any investment decisions. Please note this site also offers advertising by third parties. I do not endorse or guarantee these services. Be prudent and cautious. Do your own research, and only invest in what you understand!