The definition of stop loss order may quell some of your investing fears.
Common investing fears, according to the North American Securities Administrators Association (NASAA), include, “I’m afraid of losing all my money,” especially among millennials.
Definition of Stop-Loss Order: When Do You Need It?
Take our pal Claudia Clueless. Claudia had a record year running her store, Clueless Notions. Those flamingo buttons sold out in a jiffy – who knew?!
Claudia is going to give herself a well-deserved bonus this year.
She is thinking about investing it, but has fears about losing money in the stock market.
First of all, your fears are real and valid, but if you get some perspective, Claudia, we think you might feel better about letting your money grow.
As NASAA explains, “Look at the data on market performance over the long term (10, 20, and 30 years). Understand that while there are fluctuations, in general, the market has trended up over the long term.”
Still, Claudia, we don’t blame you. Investing can seem like a big boys’ game. Enter the definition of stop loss order.
Definition of Stop-Loss Order
As Charles Schwab gives the definition of stop-loss order, it is “an order to buy or sell a stock at the market price once the stock has traded at or through a specified price (the “stop price”). If the stock reaches the stop price, the order becomes a live market order and is typically filled at the next available market price. If the stock fails to reach the stop price, the order isn’t executed.”
So basically this means you can set it and forget it when it comes to minimizing your losses.
Say you buy some Apple stock at $228.00.
You used your bonus money to buy it. With your $2280, you bought ten shares.
Now, you really don’t want to lose your bonus money.
Enter the stop-loss order.
OK, SO WHAT IS IT?! Definition of Stop-Loss Order
A stop-loss order is an instruction you give to your broker to automatically sell a stock or asset once its price reaches a certain level. The goal is to minimize potential losses by exiting the investment when the price drops to a predefined threshold.
For example, if you are Claudia and you bought that Apple stock at $228, you might set a stop-loss order at $220. If the stock price falls to $220, the stop-loss order triggers a sale, protecting you from further losses.
How Does a Stop-Loss Order Work?
Here’s a step-by-step breakdown:
- Choose a Stop Price: Decide the price at which you want the order to trigger.
- Set the Order Type: Stop-loss orders convert to market orders once the stop price is reached, meaning your asset will sell at the next available market price.
- Monitor Your Investment: After placing the order, it remains active until the stop price is reached or you cancel it.
Types of Stop-Loss Orders
- Standard Stop-Loss Order: Triggers a market order to sell once the stop price is hit.
- Stop-Limit Order: Combines a stop-loss and a limit order. It triggers a sale at a specific price or better, giving you more control but no guarantee of execution.
Why Use a Stop-Loss Order?
- Protects Your Capital: Prevents significant losses by limiting downside risk.
- Eliminates Emotional Decisions: Automates the sell process, helping you stick to your investment strategy.
- Improves Discipline: Encourages consistent risk management practices.
Limitations of Stop-Loss Orders
While stop-loss orders are useful, they’re not foolproof:
- Market Volatility: A sudden price drop (e.g., during a flash crash) can trigger the sale even if the price quickly rebounds.
- Execution at Market Price: The final sale price might differ from your stop price, especially in fast-moving markets.
When Should You Use a Stop-Loss Order?
- When you’re investing in volatile markets.
- If you can’t monitor your portfolio regularly.
- To lock in profits by setting a stop price above your purchase price.
What Is the 7% Sell Rule?
The 7% sell rule is a risk management strategy used by stock traders to limit losses. It advises selling a stock if its price drops 7% below the purchase price. The idea is to cut losses early and preserve capital for better investment opportunities.
What is the 7% Rule? How Does the 7% Sell Rule Work?
Here’s how it plays out step by step:
- Set Your Threshold: After buying a stock, calculate 7% below your purchase price.
- Example: If you buy a stock at $100, your sell point would be $93.
- Monitor the Stock: Keep an eye on the price or set a stop-loss order at the 7% level.
- Sell Without Hesitation: If the stock hits the 7% threshold, sell immediately, regardless of your feelings or market rumors.
Why Use the 7% Sell Rule?
- Protects Your Portfolio: A 7% drop can be a sign of deeper trouble, and selling early prevents larger losses.
- Minimizes Emotional Trading: This rule provides a disciplined approach, avoiding rash decisions during market turbulence.
- Focuses on Preservation: Cutting losses early lets you conserve funds for more promising investments.
Is the 7% Rule Universal?
Not necessarily. While it’s popular among growth investors, particularly those following William J. O’Neil’s CAN SLIM strategy, it may not suit all investors or stocks. Factors to consider:
- Volatility: Stocks with high daily price swings might require a broader threshold.
- Investment Goals: Long-term investors might prefer to hold through dips rather than sell immediately.
When to Apply the Rule
- High-Growth Stocks: These can have rapid price movements, making the 7% rule ideal for minimizing risk.
- Uncertain Markets: In volatile or bearish markets, quick exits can prevent significant losses.
- Speculative Investments: If you’re trading in speculative stocks, the 7% rule can act as a safeguard.
Limitations of the 7% Sell Rule
- False Alarms: Stocks can temporarily dip before rebounding, leading to missed gains.
- Doesn’t Account for Fundamentals: The rule is based purely on price action, ignoring the underlying value of the stock.
Other Investing Options
Other Investing Options Besides a Stop-Loss Order
While a stop-loss order is a popular tool for managing risk, there are other strategies and tools investors can use to protect their portfolios or optimize their investments. Here’s a breakdown of alternatives to consider:
1. Trailing Stop Order
- How It Works: Similar to a stop-loss order, but the stop price adjusts as the stock price moves in your favor.
- Example: If you set a 5% trailing stop on a stock that rises from $100 to $110, the stop price will adjust from $95 to $104.50.
- Why Use It: Protects gains while limiting downside risk.
2. Limit Orders
- How It Works: You specify the price at which you’re willing to buy or sell a stock. A sell limit order ensures you only sell at or above a certain price.
- Why Use It: Provides control over the price at which transactions occur, avoiding unfavorable market prices.
3. Options Contracts
- Put Options: Allow you to sell a stock at a predetermined price, effectively capping losses.
- Covered Calls: Earn income on stocks you own, providing a buffer against minor losses.
- Why Use It: Options give you flexibility to hedge or profit from market movements.
4. Diversification
- How It Works: Spread your investments across different asset classes (stocks, bonds, real estate, etc.) and industries to reduce overall risk.
- Why Use It: A diversified portfolio is less likely to suffer significant losses from a single asset’s poor performance.
5. Rebalancing
- How It Works: Periodically adjust your portfolio to maintain your desired asset allocation.
- Why Use It: Helps you lock in gains and stay aligned with your investment strategy.
6. Stop-Limit Orders
- How It Works: Combines a stop order and a limit order. Once the stop price is reached, the asset is sold only if it can meet or exceed the limit price.
- Why Use It: Offers more control than a regular stop-loss order but may not always execute.
7. Dollar-Cost Averaging (DCA)
- How It Works: Invest a fixed amount of money at regular intervals, regardless of market conditions.
- Why Use It: Reduces the impact of market volatility and helps mitigate emotional decision-making.
8. Risk-Adjusted Position Sizing
- How It Works: Invest a percentage of your capital based on the risk associated with each trade. For example, allocate smaller amounts to riskier investments.
- Why Use It: Controls potential losses without relying on automatic sell triggers.
9. Hedging with ETFs or Mutual Funds
- How It Works: Use inverse ETFs or funds that move opposite to your investments to offset potential losses.
- Why Use It: Provides portfolio protection during market downturns.
10. Active Monitoring and Alerts
- How It Works: Use brokerage tools or apps to set price alerts for your stocks. Manually decide to sell based on market conditions.
- Why Use It: Allows you to remain in control without automated triggers.
Which Option Should You Choose?
It depends on your investment style and goals:
- Are you looking for automation? Consider trailing stops or stop-limit orders.
- Do you prefer flexibility? Options contracts or active monitoring might suit you.
- Want to minimize risk across your portfolio? Diversification and rebalancing are key.
No single strategy works for everyone, so explore your options and align them with your risk tolerance and objectives.
What Now?
The definition of a stop-loss order is simple: it’s a safety net for your investments. Whether you’re a seasoned trader or just starting out, this tool can help protect your portfolio from unexpected market swings.
Want to reduce risk and stay in control? A stop-loss order might be exactly what you need.
As always, do research, ask questions and speak to your financial advisor about major financial decisions.
