Starting your investing journey is a big step. One investing tool you may have heard about so far is a stop-loss order. It's a tool that can provide a safety net for some investors as they invest in the stock market.
But using a stop-loss order isn't for every investor. It depends on your investing goals and how you like to invest. It also depends on your philosophy; do market fluctuations worry you, or are you happy to hold your assets through peaks and troughs?
In this article, we're going beyond just explaining what stop-loss orders are and how they work. We'll also dive into why you might or might not want to use them as you invest. Hopefully, by the end of this article, you'll have a good understanding of how this investing tool works and if it's right for your investing journey.
What is a stop-loss order?
Volatility will always be present in the stock market. Imagine you're on a boat. Sometimes the sea is calm, and other times it's super choppy. Volatility is just like those waves — it's how much and how quickly the prices of your investments can go up and down.
Now, depending on the type of investor you are, volatility can be your friend or your foe. If you're in it for the long haul, those big waves or price changes might not bother you much. But, if you're more of a short term investor, looking to make quick moves, those waves can be hard to navigate and limit the impact on your portfolio.
In response to the ups and downs, investors can sometimes make impulsive decisions and end up losing out. That's where valuable tools like stop-loss orders come in.
Defining stop-loss orders
When you buy a stock, you hope its price will go up. But what if it starts to drop? A stop-loss order is a way to protect yourself from losing too much money. It's like setting a floor under your investment, saying: "If the price drops to this point, sell it automatically to stop the loss.”
Here's how it works: when you set a stop-loss order, you choose a price that's lower than the prevailing market price. This is your trigger price. If the stock hits this price, the stop-loss order turns into a sell stop order and will automatically sell at the next available price. This way, you don't have to watch the market every second.
For example, let's say you buy a stock at $100. You decide you don't want to lose more than $10 on this investment. So, you set a stop-loss order at $90. If the stock price drops to $90, your order kicks in, and your stock is sold to limit your loss.
For certain investors, stop-loss orders are useful for managing risk. They're like a backup plan to help you stick to your investment decisions without letting emotions get in the way. Plus, they're an automatic order, so you don't have to be glued to your screen all day.
While stop-loss orders are great for limiting losses, they may not be right for every investor or every situation where stock prices fall.
Who uses stop-loss orders in investing? And why?
Investors can use stop-loss orders as guardrails to help protect their money from big drops in price. But what type of investor usually uses stop loss orders and why? Well, different investors use stop-loss orders for various reasons. Let’s take a look below.
Stop-loss orders and short term trading
A stop-loss order (also known as a stop order) can be an important tool for investors who prefer short-term trading or day trading. Here's how:
- Protect against downside risk : This is like having a parachute when you're skydiving. If your stock's price starts to plummet, the stop-loss order kicks in and sells it off before you hit the ground too hard. It's a way to make sure you don't lose more money than you're comfortable with.
- More susceptible to short-term volatility : As prices tend to move more in the short term, traders will use a stop order to avoid potential losses when the market gets too wild for comfort.
- Automatic sell to lock in profits : Sometimes, you might be ahead and want to keep it that way. A stop order can turn into a sell stop order if the price starts to fall after rising in value while holding the stock. This allows you to keep some of those gains without having to constantly watch the market.
- Helps in the decision-making process : With a stop loss order, you set your sell point in advance. This means you're making a cool-headed decision based on your risk tolerance before things get heated. It's a helpful way to stick to your investing strategy.
- Limits emotional trading : It's easy to get caught up in the moment and make hasty decisions. A stop loss order is like a promise to yourself to stick to your plan, reducing the risk of letting emotions drive your trades.
Stop-loss orders, while useful, are not fail-safe. But for many short-term traders, they're a key part of the toolkit, helping manage those quick dips and dives in the market.
Stop-loss order and long term investing
Long-term investors are like gardeners planting trees. You know the trees won't grow tall overnight. But you're patient, looking forward to the shade and fruit they'll provide years down the road.
In other words, the primary goal for long-term investors is growing their investments over many years, not focusing on what happens in the market today or tomorrow. So, when you're investing with the idea of holding onto your stocks for a long time, your game plan looks different.
This is why long-term investors are less likely to use stop-loss orders as the day-to-day ups and downs in the market don't rattle them as much. They understand the value of their investments might drop now and then, but they're okay with riding out those dips. This makes the short-term drops look like small bumps in a long road.
Long-term investors aim for the rewards that come from patience and a steady approach. They're prepared to stick with their investments through varying market conditions.
Can I use stop-loss orders as a long-term investing strategy?
There are several strategies long-term investors use to limit their concern about sudden price movements. These include Dollar-Cost Averaging , the buy and hold strategy, and diversification. As mentioned, using stop-loss orders is not a popular strategy for long-term investors, but it can be useful at times. But how do stop-loss orders fit into this patient, growth-focused approach?
Stop-loss orders and portfolio adjustment
Although stop-loss orders are not a long-term investor’s usual cup of tea, they can be handy when looking to tweak your portfolio. There may be times when you might want to adjust which stocks or assets you're holding onto for the long run, based on how their prices are moving.
In this case, you can also use stop-loss orders to buy stocks at prices you're comfortable with. Let's say there's a stock you've got your eye on. You’re thinking: "If it ever drops to this price, it'd be a great deal." You can set a reverse stop-loss order, known as a buy limit order . This is one of the stock order types used to automatically buy that stock if it dips to your ideal price.
This strategy requires a bit of a balancing act. You're playing the long game, so you don't want to react to every little dip and rise. But by setting these orders thoughtfully, you can fine-tune your portfolio. This way, you can sell off stocks that no longer fit your long-term vision and grab opportunities to add value when the price is right.
Cautions for long-term investors
Though stop-loss orders sound like a valuable tool, there are a few reasons why you might choose to pause before using them:
- Extra fees : Sometimes, brokers charge for placing stop-loss orders. You're paying extra for a special request – this can add up over time, especially if you're not planning to sell anytime soon.
- Bad timing : These orders could sell your stocks at a low price if the market dips suddenly but then quickly recovers. It's like selling your umbrella during a brief rain shower, only for the sun to come out moments later.
- Missing out on growth : The stock market can be bumpy, but over many years, it has historically tended to go up. Building on the above point, if a stop-loss order sells your stock after a small dip, you might miss out on future gains when the market recovers.
- Emotional decisions : Stop-loss orders might tempt you to make quick decisions based on short-term market moves, rather than sticking to your long-term plan.
- Market gaps : A market gap happens when the stock's price at the market opening is quite different from its price when the market closed the day before. Sometimes, the market price can jump over your stop-loss level. This means your stock might be sold at a much lower price than you expected.
For long-term investors, the focus is more on where their investments will be years down the line, not the day-to-day changes. So, while stop-loss orders can be a valuable tool for some, they're not a one-size-fits-all solution, especially for those looking at the big picture.
Stop-loss orders – the wrap up
A stop-loss order can be a favourite among investors with a short-term approach to investing, limiting losses when the market gets rough. But when we shift our gaze to the long-term horizon, the picture changes. That's why long-term investors tend not to lean on stop-loss orders as often.
Whether you're a short-term or long-term investor, understanding how and when to use stop-loss orders can enhance your investment decisions. Like any tool, their effectiveness lies in the hands of the user, tailored to fit their unique investing journey.
