Since 1925, small-cap stocks have posted more wins than any other asset class—2% to 5% a year more than their counterparts, mid-caps or large-caps—an advantage that compounds quickly.
That’s surely a strong case for owning small-cap stocks. But before you buy, it’s important to understand that small company stocks act differently from other stocks—and therefore must be handled differently.
One area in which small-cap stocks require special handling is in stop-losses.
As a general rule, we recommend stop-losses to protect your earned profits in small-cap stock positions. But because small-cap stocks act differently from most other types of stocks, there are additional considerations.
Generally, small-cap stocks demonstrate much greater price volatility than mid-cap or large-cap stocks—fluctuations of 15% or more are typical (and they don’t need specific company or news events to trigger the volatility). It’s therefore important to keep the stop-loss in your head, not as an order to your broker.
Let me give you an example of how using a stop-loss could turn out to be a painful financial experience:
Over a decade ago, when Monster Beverage (MNST) was still Hansen Natural, the stock fell out of the sky due to just one trade. A single 600 sell-side transaction (at the time, about 15% of the average daily volume) sent the share price down 35%.
That large of a move is uncommon, but smaller 10-25% moves happen all the time with thinly listed shares (today, as I write this, there are 50 stocks trading with an intraday loss of more than 10%, and 16 of those are trading more than 15% lower).
If you had a stop-loss order in place on Monster (nee Hansen), rather than a mental stop, you almost surely would have been stopped out as any “reasonable” stop-loss would have likely been within that 35% range.
And after being stopped out, you’d have watched Monster grow into a multi-bagger that’s up nearly 500% in the last 10 years alone. Of course, there are also instances where getting stopped out down 35% would save 65% of an investment that ultimately goes to zero, but being able to exercise discretion and see how the stock responds in the moment (rather than an automatic sell) accomplishes the same goal.
The lesson here is that an investor can get paid very well for stomaching the motion sickness that comes from owning small-cap stocks, but you absolutely need to keep on your toes.
Beware Market Makers
Another potential downside to small-cap stop-losses is that they reveal your plans to the market makers.
A market maker is a broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security. Each market maker competes for customers’ orders by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order. This process takes seconds.
Market makers know when we place a sell order, so they can take out our stops by a penny (sometimes referred to as “hunting stops”) in order to add the stock to their accounts.
To avoid this from happening, I recommend mental stop-losses, rather than actual stop-loss orders.
Stop-Losses to Preserve Your Gains
So right about now, you’re wondering when stop-losses make sense.
I think a stop-loss is in order when you want to preserve the hard-earned gains you’ve achieved in a stock but you aren’t yet ready to book them.
Part of that is psychological. Automating the profit-taking process when you’ve got gains can help you avoid going “on a tilt,” a gambling term that refers to the phenomenon of a gambler who’s lost some of their winnings placing increasingly risky bets in order to “make it all back.”
Many traders use their original purchase price as the first stop-loss level once their stock has risen by 10%, 15%, or 20%. The “right” number is entirely dependent on what’s acceptable to you and the normal level of volatility in the stock. As your stock continues to rise, you can begin raising your stop-loss level to capture more and more profit.
What you want to avoid is the Monster scenario, where aberrant intraday trading stops you out of a perfectly viable stock.
If you are confident that the company and its markets are sound, you may want to use a lower stop-loss than your entry point, even if you’ve got some profits.
The rationale is that you want a stop-loss that’s low enough that it would be triggered only if demand for the company’s product has seriously deteriorated (you don’t want to get tossed out of a stock because the price wavered in a sour stock market).
Alternatively, if you’re uncomfortable being invested in a stock, using tighter stops can make you more comfortable with your investing choices. Just make sure to monitor your overall performance because the tighter the stop, the higher the likelihood that you get “whipsawed,” or immediately stopped out of a new buy.
What strategies do you prefer when setting stop-losses or mental stops?
*This post has been updated from a previously published version.