Active Investing: Managing Risk

Protect Yourself From Market Loss

There are many investors who don't know what to do to protect themselves in the stock markets. It comes as no surprise: every self-proclaimed guru claims to have the best strategy since sliced bread. What these "gurus" don't provide is details - as least not free of charge.

Fortunately, there are several simple strategies that you can use to protect yourself from downside risk in both bull and bear markets. In this article we will cover sell stops, sell stop limits, buy stops and buy stop limits, as well as tips and techniques you can use to place them effectively in any type of market.

Sell Stops and Buy Stops Cap Losses

One way to protect your downside in the markets is through the use of sell stops and sell stop limit orders. A sell stop order, often referred to as a stop-loss order, is an order to sell a stock once it reaches a certain price. If the stock reaches the stop price, the order is then executed and shares are sold at the market price for the stock. When the order is to sell, the stop is always placed below the stock's market price.

A stop-limit order is an order to sell a stock once a specific price is reached, as long as the price does not fall below the limit specified by the investor. If the stock reaches the stop price, the order is converted to a limit order. The benefit of the limit order is that you have more control over the price at which the sell will be executed.

With both types of orders, if the stock doesn't reach the specified stop price then the order will not be filled.

Putting Stops in Place

The proper use of sell stop and sell stop limits are a key to protecting your investments. These tools keep the decision-making process simple and unemotional – even when the market is in turmoil. They also help prevent you from rethinking when to take profits and when to jump ship on fast-sinking stocks.

While there is no magic number or percentage used to set stop orders, generally there are two common methods used to place them:

1. Place the stop price below the support level. You can identify a support level by looking at a chart and finding the lowest points for the stock and previous points where it stopped dropping. A break below this point would generally mean that there is a possibility the stock could head lower.

2. Place your stop price 5-15% below your purchase price, depending on your level of comfort. This will prevent you from riding the stock all the way down and help you keep your losses manageable. Also, just knowing what your downside is allows you to determine (and prepare for) a worst-case scenario.

In addition, you can adjust your stops upward as the stock moves up by looking at the point where it stopped dropping previously and then setting the sell stop or sell stop limit just below that level.

How to Avoid Being Stopped Out

When a stock falls to the sell stop price that you set and your shares are sold, this is referred to as being "stopped out". So, while sell stop and sell stop limit orders are a good way to keep you on the right side of the markets, there will be times when you can hit the sell stop or sell stop limit just before the stock starts another ascent.

How can you avoid this? As a general rule, you want to avoid placing stops at round numbers such as $36 because many traders place their stop orders at the round numbers. Once the stock hits this round number, it triggers one last round of selling. The key to choosing a more successful stop is to place your order at an odd number with enough room to account for the last potential round of selling. 

For example, if many traders have their sell stops in at $34, you should place your sell stop at $34.15 to provide enough room for a round of sell orders to go through without triggering your sell stop and incurring an unnecessary loss for you. While you can't determine exactly where other traders will place their stops, attempting to account for this will help decrease the chances that you will be stopped out on a temporary drop.

For Short Sellers: Buy Stop and Buy Stop Limit Orders

If you are playing the short side of the market, a buy stop order or buy stop limit order can be used to protect your downside if a position moves against you.

Buy stop orders and  buy stop limit orders can be used to protect a profit or loss on short sales. A short sale is the act of selling a stock that you don't own with the goal of buying the stock back at a lower price to make a profit. It the stock rises, you buy it back at a higher price to create a loss. A buy stop order is used to limit a loss or protect a profit on a short sale and is entered above the market price. When the stock reaches this price, the trade is executed at the market price.

A buy stop limit order is an order to buy a stock once a particular price is reached, at which point the order converts to a limit order. The buy order will only be executed at the specified limit price or better.

Setting Up Buy Stops and Buy Stop Limits

Like sell stops and sell stop limits, placing buy stops and buy stop limits can be tricky. Fortunately, there are general rules that apply to where they should be placed:

1. You can place them just above the resistance level of a stock. This is the point where a stock has trouble moving higher. This level forms when investors purchase large amounts of the stock just before a decline with the idea to sell it when it hits that point again.

2. You can place them about 10-15% above where you initiated the short sale if the position is volatile. These can also be adjusted downward to protect profits by looking at the highest point the stock reached on the previous rally.

How to Avoid Hitting the Buy Stops or Buy Stop Limits

Like with sell stops, you want to avoid hitting your buy stop and having the position drop off once the short position is covered (you have bought the shares back at a higher price). A lot of the same techniques that you use on sell stops and sell stop limits can also be applied in this instance. These include avoiding round numbers and instead placing buy stops and buy stop limits at odd numbers.

When your stock does hit the buy stop or buy stop limit, you have a couple of options.

1. Watch and see how the stock trades.

2. Go back in and place another buy stop or buy stop limit to protect your downside on the short (this is a bold move).

However, what you choose to do at this stage really depends on your overall level of comfort.

Conclusion

It is clear that by using sell stops, sell stop limits, buy stops and buy stop limits, traders can protect themselves from volatile markets and prevent massive portfolio losses. That said, you should adapt the way you use these tools to your comfort level. If you use them prudently, they should keep you on the right side of the markets.