I recently received a question from a subscriber about using stop-losses. It is a common question, so let’s dive into it here.
Stop-losses, or more fully, stop-loss orders, are trading orders that are placed to execute a sale automatically if a stock falls below a specified trigger price. The idea is that these orders can prevent a small loss from becoming a large loss. It can also be used to lock in profits.
These orders are often placed at 10% below the current price, providing some leeway for regular market fluctuations but also “tight” enough to prevent a large loss. There is no precise rule for where to place the order.
Like all tools, each investor should decide for themselves which ones they like. Stop-losses may be useful for growth and momentum investors. Also, stock and option traders with a focus on shorter-term gains can make effective use of stop-losses a critical component of their strategies.
But, what might be exactly the right tool for these strategies can be exactly the wrong tool for value investors with a 1-3-year horizon and a tolerance for volatility.
Why Not to Use Stop-Losses
My view, which I use in my Cabot Undervalued Stocks Advisor and Cabot Turnaround Letter advisories, is to not use stop-loss orders. If there is disastrous news, the shares probably already reflect most of the damage. Truly bad news results in a gap-down opening, where the stock’s first trade is at a much lower price than the prior close. This renders a stop-loss ineffective, as no trades are executed between the prior close and the now-reduced market price.
Stocks frequently overreact to bad news – investors “shoot first and ask questions later,” as the saying goes. This can initially drive a stock down sharply, only to have it rebound soon after. Our preference is to avoid a forced sale, which allows us the time to understand and think about the news to make a more-informed decision. For investors who sell quickly, human nature can make it nearly impossible to repurchase the stock upon further reflection. In our experience, when we have sold on bad news and then repurchased later, it invariably has been at a price higher than our exit price.
Our value stocks can be volatile. Often, we buy early – that is, when there still is some bad news that may yet come out. And, a value stock can show promising gains, but then experience a mid-recovery setback, sending the shares back down on a temporary change in sentiment but not on an unfavorable change in the long-term fundamental outlook. In these cases, stop-loss orders force a sale at what might be exactly the wrong time, and the investor forgoes future gains.
A common question with stop-orders is where to place them. Many investors use a price that is 10% below the current price. Some choose a “tighter” price (closer to the current price) while others choose a “looser” price (further below the current price). We don’t know what the right level is. Too tight, and the stock is probably going to be sold quickly due to random market noise. Too loose, and the order doesn’t provide much protection.
One nuance of a stop-loss order is that the order becomes a “market” order. Once the order is triggered, the trade is executed “at the market,” wherever that is. There is no guarantee that the order will be executed at the chosen trigger price. Investors can place a “stop-limit” order, but if a stock drops below the limit price, the trade won’t be executed. In fast markets, these orders may not be of much value.
Patience Can Lead to Profits
Stop-loss orders often are compared to an insurance policy. Like home insurance, they are seen as a tool to prevent a financial loss if an investment burns down. However, the fire that burns down a house won’t “over-burn” a house – it can only burn down to the ground. Also, a burned-down house won’t work hard to recover from the damage, it just sits there, smoldering. Stocks, however, do get “oversold” and managements are highly incentivized to mitigate the damage, which they often do.
With my investing, I never use stop-losses, for the reasons outlined above. Critically, I accept the risk that I may take a large loss on a stock (not a pleasant experience, for sure). Also, I have a lot of patience when things unravel.
If you’re a value investor, being patient can often lead to bigger profits down the road.
Editor’s Note: This post was excerpted from the latest issue of Cabot Undervalued Stocks Advisor. To read more, click here.