How to Protect Your Investments With Stop Losses
Quit stressing about unpredictable market crashes and protect your wealth.
Investing can be stressful, right?
When I first started investing, I couldn’t help but anxiously check on my stocks every day.
What’s the market doing? Was this a stupid investment? Did I jump in too soon? Too late?
With time and education, I’ve learned not to obsess over my investments and to just trust my plan. But that doesn’t totally erase the emotional side of investing.
The “greatest” or “safest” companies can tank in an instant for whatever reason. Corporate scandals, black swan events, pandemics. These events happen, and they can turn portfolios upside down.
Even the most emotionally-hardened individuals aren’t immune to financial stress.
If you’ve ever worried about your investments tanking, you should consider protecting your portfolio with stop-loss orders.
What is a stop loss?
As the name suggests, stop-loss orders stop your investments from dropping beyond a certain price point. They minimize losses and lock in gains. How? By setting “stop prices,” which trigger sell orders once a stock’s price dips below a pre-determined dollar amount.
For example, if you bought a share of The Bacon Company (TBC — not a real company) for $100, you could enter a stop-loss order for $90 (i.e. your stop price) to limit your downside.
If TBC’s share price dropped below $90, your stop loss would trigger a market sell order.
But there are several variations of stop losses to consider.
Stop-limit orders work just like stop losses — but with an additional wrinkle. When you execute a stop-limit order, you’ll designate a stop price and a limit price. This ensures you’re selling your shares at a set price rather than whatever the market rate is at the time.
Using the above example, in addition to setting a $90 stop price, you’d also set a limit. In this instance, you could set a limit price between $85 and $90 to protect against a plummeting stock price.
But what if TBC invents a new type of bacon (or something else revolutionary in the bacon world) and their stock surges to $150? Stop losses and stop limits aren’t as effective since they’re static — your stop price is still $90.
That’s where trailing stop-loss orders enter the equation.
Trailing stop loss
With a trailing stop-loss, you don’t have to endlessly place stop-loss orders to adjust to everchanging stock prices. As the name implies, this mechanism trails rising stock prices. Your stop-price increases with the share’s upward movements.
When you place a a trailing stop-loss order, you can set your trail amount in dollars or as a percentage.
Let’s say you buy a share of TBC for $100 and set a 10% trailing stop. Initially, your trailing stop price would be $90. But, if TBC rose to $150 per share, your stop price would rise to $135 (i.e. 10% less than the current price). Your trailing stop price increases as TBC’s price increases.
However, your stop price does not decrease. If TBC rose to $150 and then dropped to $130, your trailing stop will trigger and issue a market sell order.
Finally, there are trailing stop-limits, which combine the limit and trailing mechanics. Trailing stop limits function the exact same way except you set a limit price too. It’s the most comprehensive stop-loss protection of the bunch.
The benefits of stop-loss orders
Beyond limiting your downside risk, there are a couple of other benefits of stop-loss orders to consider.
First, they’re free. It’s a safeguard you can use to protect your portfolio at no cost.
Second, they take emotions out of the decision-making process. Emotions make us human, but they also make us lousy investors. If you’re like me when I first started investing, you get antsy when stock prices have huge swings.
We can become emotionally attached to our investments. It’s hard to decide to sell a stock when it’s reeling. It’s easy to justify holding onto a losing stock.
“It’ll turn around.”
“It’s just the market, we’ll bounce back.”
And it might, but that depends on the situation.
The same process applies in the reverse scenario. A stock could surge and have an inflated price tag. One it starts to return to earth, it’s easy to convince yourself to take the wait-and-see approach.
Stop-loss orders remove this hesitation from the equation.
How to place a stop-loss order
There isn’t a stop-loss toggle you can just switch on and off. You have to place an actual order. Let’s run through the process — using Fidelity’s platform as an example.
After you purchase a stock (or whenever, there isn’t a time limit), go to your trade screen.
From here, you’ll enter the ticker of the stock you want to protect with a stop loss. Assuming you want to cover your entire position, you’ll select “Sell all shares” under the “Action” category.
Select your desired type of stop-loss under “Order Type,” which includes…
- Stop loss
- Stop limit
- Trailing stop loss ($)
- Trailing stop loss (%)
- Trailing stop limit ($)
- Trailing stop limit (%)
Depending on your selection, you’ll fill in a stop price, trail amount/percentage, or limit.
Lastly, you’ll select a “Time in Force,” which just determines if you want the stop-loss to last for the day or until you cancel it. You’ll select “Good til’ canceled.”
Preview your order to make sure everything checks out. Then you’re finished!
How much should your stop loss be?
There isn’t a universal dollar amount or percentage for your stop-loss orders. It depends on the stock and your investment horizon. An active trader will have a lower threshold than a long-term investor. And stocks that drastically fluctuate need more slack, so to speak, if you want to avoid premature sales.
If I’m locking in gains for stocks that have performed well, I usually use a trailing stop-loss of 10% — but that’s just me.
Words of caution
Before you set stop losses for each of your investments, I have a few words of caution.
First caution: Stop-loss orders don’t mitigate all price movement risks. Volatile stocks could trigger your stop-loss order and rebound just as quickly as they dropped. So, be wary of placing these protections on stocks that tend to have drastic swings. Otherwise, you’ll prematurely sell your shares and miss out on gains.
Second caution: Unless you initiate a stop-limit order, your sell order becomes a market order once the price hits your sell percentage or dollar amount. So, your actual sale price could be much lower than your stop price if the price is tanking fast enough.
Third caution: Stop-losses should still align with your investment plan and horizons. If you have a long-term hold strategy, stop-losses might not always be applicable.
Also, a little FYI, you can’t place stop-loss orders on OTC stocks or penny stocks.
If you’re an investor, it’s important to at least consider adding stop losses to your portfolio. You never know what can happen — the market is unpredictable.