## Stop losing value from a declining price

March 4, 2017

### background

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:

1. Company performance. ‘Good’ companies attract investors. Conversely, ‘distressed’ companies repel investors.
2. 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.
3. 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:

1. 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].
2. 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.

### conclusion

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.

## Conditional orders for stock trades

September 6, 2014

[The basic concept of ‘price diligence’ was inserted on 3/20/2015.  The MockTrades planner was updated on 12/11/2014]

## The trading arena; a simplified description

Stocks and other securities are traded for cash by an auction process in the stock market.  The participants are investors who make offers, brokers who generate orders, and traders who finalize the orders.  Individual investors submit offers to brokers through a computer terminal or by direct communication.  Use of the computer terminal gives the illusion of directly participating in the auction process, but there are several intermediary steps occurring at the speed of light along with a few brief delays.  The first delay is at the brokerage firm where all offers are filtered, recorded, and transmitted to traders in the stock market.  At any moment in the stock market, there are millions of orders to buy and sell securities.

As an individual investor, you may place one of several types of trading orders in your broker’s trading platform.  The simplest, called a market order, merely specifies the number of shares to be traded.  The market order is filled immediately unless a time delay is imposed by an undersupply of available shares.

A limit order specifies the preferred price of the trade.  This order is filled when the next available price either matches the limit price or provides a better price {in other words, the limit price is YOUR minimum selling price or maximum purchasing price}.  There is only one opportunity for the limit order to be filled after it is placed in the market.  In rare instances, an unusual market event may shift the next available price out of your limit’s price range, in which case the order is cancelled without an exchange of cash for shares.  Your only recourse is to place a new limit order.  The limit order is used to protect from shifting prices.

Stop and stop-limit orders are useful for protecting against losses of investment capital.  The stop is a specific price at which your trading order will be submitted as a market order.  Your stop is stored in the exchange’s computer until it is submitted or expires at the end of a time period called the time-in-force (“TIF”).   The market order is then filled immediately at the next available price, which may shift to a better or worse price than the stop’s price.  The stop-limit is a specific price at which your trading order will be submitted to the stock exchange as a limit order.  It too has an expiration date.  The limit order protects your trading price until the order is filled, cancelled by the expiration date, or cancelled by an unusual market event. Your only recourse to a cancelled order is to place a new stop-limit order.

Trailing stop orders provide opportunities to seek a better trading price in the market.   The trailing stop is a specific point spread (1 point equals \$1) by which the stop price will trail the movement of market prices toward a better price.  In general, the trailing stop can move toward a better price but won’t move toward a worse price.  The trailing price resides above or below the market’s price by the cash value of the point spread.  The trailing price adjusts upward with market prices when you offer to sell shares and downward when you offer to buy shares.  Reversal of the market price initially stops the adjustment of the trailing price and eventually triggers the submission of a market order.   The trailing stop order is stored in the brokerage firm’s computer until its expiration date or the submission of a market order.

## Setting the stop

Trading platforms are designed to set stops above the ASK and below the BID of a market quote.  For example, when you offer to purchase shares with a stop or trailing stop order, a market order is submitted when the market’s ASK increases to the stop price.  Or when you offer to sell shares with stop-limit order, a limit order is submitted when the market’s BID decreases to the stop price.

The likelihood that daily fluctuations in market price will trigger any type of stop order depends on the width of the margin between the stop price and market price.  Exceptionally narrow margins may trigger an order the same day and exceptionally wide margins may cause the order to expire before being triggered.  The width of the margin depends on your trading strategy.  What is your acceptable price range for buying and selling a security?  Do you prefer using the same margin for all stops or customizing the margin based on price volatility?  The SmallTrades MockTrades4 is a free, useful worksheet (in Microsoft’s Excel™ format) for customizing the stop margin of your trading order.

## Applications

Stop and stop limit orders are typically used to protect against capital losses when market prices are declining.  Trailing stop orders can help maximize a sales price or minimize a purchase price.   Examples of these applications can be found online in the educational materials of brokerage firms.  This user-friendly version, “Secure your position”, was a free download provided by the Commonwealth Securities Limited (“CommSec”), Sydney, web site.