The market value of your stock equals your principal (i.e., the amount you invested) plus any profit or loss from price fluctuation. The market price that moves below what you paid to purchase the stock will produce a loss of principal if you sell the investment. Here are several risk factors that may drive stock prices downward:
- Company performance. ‘Good’ companies attract investors. Conversely, ‘distressed’ companies repel investors.
- Industry performance. Business cycles can affect the sales of products from an entire industry. For example, sales of new automobiles declined during the Recession of 2008.
- Market cycles. Aside from business performance, the entire stock market is subject to periods of declining prices due to massive selloffs by investors.
The risk of an extreme loss can be prevented by setting a stop-loss price (“stop”) to sell part or all of your shares.
ways of setting the stop
The systematic way is quite simple. If the market value is below your invested principal, then select an absolute loss or a fraction of the principal. Examples:
- Absolute loss. Suppose you invest $5,000 in 100 shares of stock (i.e., $50/share) and you can tolerate a loss of $1,000 should the price start to fall. Regardless of future prices, you choose to stop the decline at $1,000 below the original $5,000 value. In this example, the stop would be $40/share [stop = (value – loss)/shares = ($5,000 – $1,000)/100].
- Fraction of value. Suppose you can tolerate a 10% loss from an investment originally valued at $5,000 for 100 shares. Ten percent is one-tenth of 100, which is equivalent to a decimal number of 0.10. The stop would be $45/share [stop = (1.00 – decimal)*value/shares = (1.00 – 0.10)*$5,000/100].
The technical way is based on the stock’s historical prices. If you want to minimize the chance of a sale, set the stop at the lowest price from the past 5-10 years. Beware that setting the stop at a historical low may incur a steep loss. Other ways involve the more complicated analyses of trendlines, moving-average lines, or price statistics.
Another way is to adjust the price gap (gap = market price – stop) to the growth of capital gains. As the market price increases over time, choose a narrow gap to protect the capital gain or a wide gap to reduce the chance of a trade. Generally speaking, widening the price gap will reduce the chance of a trade at the risk of incurring a bigger loss.
add a limit price (“limit”) for extra protection
A brokerage firm will enforce your stop order for 30-90 days depending on the firm’s trading platform. The firm’s computer activates the order when the latest market price reaches the stop. The order is then filled at the next available price. In a chaotic market, the price could plunge below your stop to an exceptionally low value at the next available trade, resulting in a bigger loss than you planned. You might be able to prevent this result by setting a limit slightly below the stop. The trading order would be filled somewhere within the stop-limit price zone unless the transaction is cancelled, unfilled, when the next available price dips below the limit. The limit helps protect the extent of your loss.
who should worry about an extreme loss?
Nobody’s immune, but long-time investors have the least concern. Investment strategies such as dollar-cost-averaging and automatic-dividend-reinvestment plans will help protect against damages from periodic bear markets. Short- and intermediate-time investors are at greater risk for incurring an extreme loss from market down-cycles. For example, families who are saving to pay college fees or to buy a home risk big losses from a bear market.
Stop orders are used to set the price for buying or selling exchange-traded products such as stocks, ETFs, and REITs. This article discussed the use of a stop-limit order to sell a stock in a declining market. Brokerage firms may restrict the duration of stop-limit orders to 30-90 days after which the order is cancelled without a transaction until you renew the order. Periodic renewals allow you to reconsider your strategy in light of the prevailing price trend. In a downtrend, simply renew the order. In an uptrend, you may wish to protect a growing profit by resetting the stop-limit order to higher prices. Click on this link to skimming a profit for another perspective on protecting a growing profit.
Copyright © 2017 Douglas R. Knight