A Stop Loss Order Won't Always Protect Your Portfolio
Despite the Risk Management Benefits, Don't Succumb to a False Sense of Security
Long a preferred tool of traders, a stop loss order can be a great way to protect your investment portfolio under certain circumstances. Despite its benefits, it isn't perfect. Too many inexperienced investors tend to incorrectly assume that it can shield them from serious losses under scenarios in which it wouldn't have done much, if any, good. That is dangerous because these well-meaning men and women might enter into a transaction under a false sense of security, only to realize their error after it was too late and much of their equity has disappeared.
What Is a Stop Loss Order?
It might help if we review what a stop loss order is and how it works before we get to the limitations of using one when placing a trade. First, let's deal with the definition: What is a stop loss order?
A stop loss order, also known as a "stop order", is a type of trade placed with a brokerage house that tells the broker to hold on to the buy or sell trade ticket until a specific price is reached, at which point it should convert into a regular market order and be filled at whatever price is available. There are two types of stop-loss orders:
- A Buy Stop Loss Order - Entered at a price above the current market price, a buy stop loss order is used to limit a loss or protect profits already earned on a stock that has been sold short, especially to avoid a margin call. For example, imagine that you shorted 100 shares of XYZ at $5 per share. Company XYZ does not pay a dividend so you won't be responsible for any replacement payments to the share lender. You don't want to lose more than $600 so you desire to close out of the position if it goes to $11 per share ($6 increase in share price x 100 shares = $600 loss). In this case, you would place a buy stop-loss order at $11. When and if the stock hit that price, it would convert to a regular market order and be filled at whatever price was available at the time based upon the bid/ask liquidity.
- A Sell Stop Loss Order - Entered at a price below the current market price, a sell stop loss order is used to limit a loss or protect profits already earned on a so-called "long" stock position that you own. For example, imagine that you bought 100 shares of company ABC at $25 per share. The price appreciates to $55 per share. You want to hang on to it in case it goes higher but you also desire to walk away with at least $50 per share if the market crashes. As a result, you enter a sell stop loss order at $50 per share. When and if the stock hits that price, it will convert to a regular market order and be filled at whatever price was available at the time based upon the bid/ask liquidity.
There is also a special sub-type of trade known as a "trailing stop loss order". Basically, it adds a layer of automation to the stop loss order insofar that it adjusts itself based upon either an absolute dollar amount or a percentage of the all-time high or low hit during your holding period. For example, with the sell stop loss order we discussed, imagine that you said you wanted to place a trailing stop at $3 less than the highest price achieved on ABC shares. In this case, if the stock hit $60, the stop loss would not be $50 per share, it would adjust itself to $57 ($60-$3=$57). Each time a new high was reached, the stop loss level is increased accordingly. This means if the stock went to $65, the stop loss would adjust itself to $62 ($65-$3=$62).
When Would a Stop Loss Order Fail to Protect an Investor or Speculator?
In some situations, the stop loss order becomes all but useless at best, and can severely harm you at worst. Let's look at a few hypothetical examples.
Imagine you shorted 1,000 shares of a fictional company, Acme Industries, Inc., at $10 per share. The stock doesn't pay a dividend so you don't need to worry about covering the dividend payment replacements to the lender.
You don't want to lose more than $5,000, so you place a buy stop-loss order at $15 per share, telling your broker, "If and when the stock hits $15 per share, immediately enter an order to buy back the 1,000 shares I borrowed, paying $15,000, so I can't lose any more money."
Sounds great, right? Not so fast. It isn't unheard of for companies to announce stellar results when the market is closed. Other times, a competitor or financial buyer comes in and makes a tender offer to acquire the whole firm at a substantial premium. This can cause the stock price to open or immediately readjust higher without hitting the interim numbers.
Imagine that you are sitting at your desk one morning and prior to the opening bell, Acme announces that it is being acquired for $25 per share. The stock market opens and your buy stop loss order is triggered.
Under this scenario, the stock's price immediately adjusted from $10 to $25. In other words, there was never an opportunity to repurchase the shares between $10.01 and $24.99 because the stock went straight to their new level as investors rationally concluded they wouldn't part with equity unless the buyer matched what the upcoming acquirer was wiling to pay. Your market order would have been put in and likely filled at $25 per share, or $25,000. Your loss: $15,000, or three times what you anticipated.
This isn't a joke or something you should take lightly. I wrote about a 32-year-old small business owner named Joseph Campbell who had around $37,000 in an E-Trade account only to find himself siting on $144,405.31 in losses practically overnight, leading to a $106,445.56 margin call. A stop loss order wouldn't have done him a tremendous amount of good or offered any meaningful protection because the shares of the firm he shorted were around $2 when the market closed and opened at $14 only to climb quickly enough that he had to fill at roughly $18.50.
The same goes for ordinary stocks, held outright, that you think you've protected with a sell stop loss order. Let's say you were sitting on 1,000 shares of McDonald's Corporation at $114.50 per share for a total of $114,500. You want to make sure you always have $100,000 or more so you put in the order at $100 per share. However, there could be a so-called "flash crash" when the stock immediately went to $80 without ever touching a price between $114.49 and $80.01; an instantaneous adjustment in which your trade converted to a market order and you dumped your ownership at $80,000. Imagine the horror if the crash quickly corrected itself, has been the case in the past, and you watched your shares close out the day or week at over $100,000.
This is especially dangerous in cases where the company might declare bankruptcy or has some sort of wipe-out risk. When G.T. Advanced Technologies, an Apple supplier, shocked the financial markets by announcing it was seeking protection from the courts, the stock was obliterated all but instantaneously.
One Way to Offer Some Degree of Added Protection Is To Use a Stop Loss Limit Order
Although it wouldn't protect against these particular dangers, one way to add additional safety is to use a stop loss limit order. This is another type of stop loss order that, upon being triggered, converts into a limit order, not a market order. A limit order won't execute unless a specific price has been reached.
Imagine you hold 1,000 shares of The Walt Disney Company at $120 per share, or $120,000 for the entire stake. You enter a sell stop loss limit order for $105 per share with the limit price at $100. If the stock declines to $105 per share, the limit order would be released. The limit order tells the broker, "Don't sell my stock unless the price is at least $100 at the time it is sent to be fulfilled". In this case, if there were a flash crash and Disney suddenly opened at, say, $80 per share, you shouldn't discover your stock has been sold out from underneath you at a price far below what you would have accepted. The reason? Although the stop loss was triggered at $105 per share, the limit order conditions ($100 per share or better) weren't fulfilled. You should still be holding 1,000 shares at a total value of $80,000.