Should you use Stop Losses in your investment portfolio?
Are you looking for the auto-eject button? A parachute? A bullet proof vest?
Do you think if you scream “UNCLE,” the pain stops?
Or at least that’s what you’re hoping a stop loss will do. Right?
Reducing risk while still having the upside potential of the market is what we all want. A stop loss manages your risk by automatically executing a sell order once your position drops to a pre-determined level. A price level that you set when you submit the order.
Let’s start with an example of a stock that you purchased at $50 per share. You enter a stop loss order at $40 in fear the stock could drop below $40. You’ve determined that is your maximum threshold you’re willing to lose. It’s your maximum pain point.
Not so fast. What happens after your order goes to market?
You bet! A stop-loss gets submitted as a market order when it hits your pre-determined price level.
Okay, so if that happens, and the order does execute, then what happens?
I’m glad you asked. You can stay in cash, buy another stock or decide to get back in the same stock.
How do you know when to get back in on the position or the market?
What if the price goes back up before you can buy again?
The only thing a stop loss ensures is the execution of your trade at a price below your current share price.
It doesn’t guarantee that the sell order will be at the same level of your stop loss order. It may sell far below it. So getting back in or deciding what to do if the price goes up, is well, up to you.
Intelligent investors know better than to time the market. While prices are the metric for successful investing, the fundamentals of the underlying security we believe are the basis for trading. A change in price should be a sign to reevaluate the stock and your investment thesis.
If your analysis holds then time should prove fruitful.