Stop-Loss Orders: Friend or Foe

I originally posted this same article on my LinkedIn profile but wanted to share it elsewhere as well. That being said I felt my website would be a great landing area for something I specialize in. Enjoy the article and feel free to share!


Understanding the Danger of Stop-Loss Orders

The return of dramatic market volatility brought to mind a question I’ve been asked by many people during my investing career – “Should I use a stop-loss order to protect my stock holdings?” Individuals often lose their nerve for holding investments during down periods in the market and later wonder how selling at the lows might have been avoided. They believe a stop-loss seems like a good idea. In theory it is something you can set up in your brokerage account and leave as a standing order. That is to say your order stays in place until you remove it from the account.

Let’s give an example. Say you own 100 shares of Apple (AAPL) and the closing price on August 17 was $117.16. You don’t want to lose more than $1,000 on the position so you institute a standing stop-loss order to sell the stock if it hits $105.44. In principle this sounds like a reasonable idea. Your tolerance for loss on the position is $1,000 and you now believe you put in place an order that will minimize your loss to that amount. On August 21 Apple closes at $105.76 after an awful week and nearly triggers your stop-loss. You feel good though thinking you can’t lose more than that $1000 due to your stop-loss. In practice it could be a much wider loss than $1,000. Stop-loss orders are executed once the stock hits the stop-loss trigger or lower. In other words, once the stock breaks the stop-loss price it becomes a market order.

On Monday August 24 we see a perfect example of how your stop-loss order can be damaging. Many stocks and ETF’s opened dramatically lower that morning as the market struggled to find equilibrium. Some stocks were as much as 30% lower at the market open, but quickly recovered to levels more in line with the overall market decline of 4-5%. Unfortunately on your Apple stop-loss order you were executed as soon as the stock broke $96 at the open of the market. You sold somewhere between $92-$94 and locked in a loss of approximately $2400. It didn’t matter that Apple quickly recovered to a level above your stop-loss price or that it closed the day down just 2.5% at $103.12.

Stop-loss orders are sound in principle, but can be awful in practice. Highly volatile markets such as those we are currently experiencing highlight the risks of using stop-loss orders. So what are your alternatives? You could buy put options at a specific stock price. A put option gives you the right, but not the obligation to sell your stock at the put price, prior to or on the expiration date of the option. Of course you have to pay a premium for the put option and it has an end date. The longer the option time frame the more expensive the option at a given stock price. Another option is to use a sell limit order. This would enable you to sell Apple at a certain price, ~$105 in this case, or better, but nothing below $105. This really doesn’t help our fictional investor since the limit order expires each day and it is likely impractical to place a new limit order each day.

What should one do then? It is best for an investor to understand their tolerance for losses, and attempt to structure their portfolio appropriately. They also need to understand and accept the appropriate time frame for each of their investments such that they are able to absorb losses over the short-term in the riskier part of their portfolio. This gives the portfolio the opportunity to ride out the cycles of the market and benefit from long-term returns. For more information visit my firm’s website at orcontact us via email for additional help.

Magnolia Lane Financial Advisors, LLC is a Registered Investment Adviser. Custody services and other brokerage services provided to clients of Magnolia Lane Financial Advisors, LLC are offered through Charles Schwab & Co., Inc., member FINRA/SIPC/NFA. This article is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Magnolia Lane Financial Advisors, LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Magnolia Lane Financial Advisors, LLC unless a client service agreement is in place.

Thank you for reading!

Eric Gerster