Stop-Losses Are the Most Important Trading Tactic

Stop losses allow investors to protect from risk and realize gains

Times Square
Times Square. Spencer Platt

This should not be considered personalized trading advice.

Using "stop-loss" orders is the most important aspect to penny stock success. Whether you are new to trading shares or have been investing for decades, properly implementing this special type of trade will make all the difference.

Stop-losses are trading orders whereby an investor will liquidate their position, automatically and immediately, if the shares dip to a certain value.

This preserves capital and protects from further downside.  When a penny stock plummets, many investors "go down with the ship," while those with stop-loss orders in place would have sold well before the major losses.

Consider an investor buying shares of "Trendy Penny Stock" company at $4.25.  Right away, they enter a stop-loss order to trigger if the shares dip to $3.90, at which point the entire investment would instantly be sold.

  • If Trendy Penny Stock prices rise, the shareholder still owns the shares and enjoys the increasing value of the investment.  
  • If share prices fell dramatically, the stock would be sold when they hit the stop-loss price of $3.90.  

What if Trendy Penny Stock slid all the way to $2? The shareholder's brilliant stop-loss protected them from the majority of the fall ($1.90 per share in losses, or 53%, to be exact).

The downside of a stop-loss order is the risk of getting "stopped out." In the example above, imagine the shares dipped for a few minutes to $3.90, then recovered and climbed higher.

  The stop-loss order would have triggered, resulting in the sale of the investment, and the shareholder would have sold at a loss, and then missed out on any subsequent gains.

The threat of getting stopped out is why choosing a great stop-loss level is so important. If someone routinely sets their price too close to the current share value, they may be at risk of getting stopped out simply due to the standard volatility of the shares.

For example, setting stop-losses one percent below the current share price will often result in trading losses, as the investor frequently gets stopped out by typical and minor price fluctuations.

The optimal degree of the stop-loss price is different for every investor, and sometimes may be as low as a few percent. For others the level could be as great as 30 percent, sometimes even larger. For example, some investors may set their stop-loss price at 70 cents for shares which were bought at $1. Whatever level each person chooses represents their total downside risk.

Stop-loss orders are very important with any type of investment, but even more so with penny stocks.  While IBM,  GE, or Disney are less likely to drop significantly, penny stocks very often move dramatically, and investors must protect themselves from major 50%, 75%, or even 100% downward slides.  

With penny stocks, our experience has been that stop-losses in the range of 10 to 15 percent below the purchase price tend to be the most effective.  Of course, this depends very much on the volatility of the underlying shares, and each company's unique situation.  Thus, setting effective stop-losses is as much of an art as researching the underlying investments in the first place.

 

Usually, stock brokers will allow for stop-losses to be set up ahead of time and triggered automatically.  However, they are not so compliant when it comes to penny stocks or thinly-traded shares. While some brokers may be helpful in setting up automatic loss limits with low-priced shares, most will not.

If your broker will not allow for stop-loss orders, what should a penny stock investor do? We suggest using "mental stop-losses," whereby you commit to your automatic selling price right when you buy the shares.  For example, you purchase your investment at $3.96, and decide on a stop-loss in your mind of $3.70.  At any point, if the stock dips to $3.70, for any reason, you immediately sell.  

The major problem with mental stop-losses is that investors rarely stick to them.  Often, as the shares fall, an investor may predict reasons why the investment will make a comeback, or they may justify to themselves why they should lower the stop-loss price.

 This type of investor may as well not use stop-losses if they aren't going to fully commit to sticking with them.  

If your biggest loss from your worst mistakes was only five percent, you would be able to make many poor investment choices before it would matter. "Live to fight another day," should be the mantra in penny stocks.  

Trailing stop-losses are also a great way to protect gains you've made.  As the share value of the underlying investment rises, you may want to adjust your stop-loss trigger price higher.  For example, you buy shares at $1.54, and choose that your stop-loss level is $1.40.  The shares then climb towards $2, so you readjust your stop-loss to $1.70.  Shares go higher to $2.85, and you may want to up your trigger price to $2.50.

Taking this example further, perhaps the shares then dip back to $2.44... you would have sold as soon as they crossed your trigger price of $2.50.  Your trailing stop was hit so you took your profits. 

An effective strategy to protect against downside, and preserve potential gains, is to use multiple stop-loss prices.  For example, you may commit to selling a portion of the shares at one price, then another part at an even lower level.  Using our example once more, when the shares hit $2.85, you may have established a mental stop-loss at $2.50 for one-third of the shares, then another at $2.00 for the remaining two-thirds.

There are issues using stop-losses (whether mental or through your broker) with volatile investments, as well as with thinly traded shares.  If an underlying penny stock only trades a few thousand shares per day, or perhaps they have frequent price swings of 20% or more, stop-losses will quickly prove inappropriate and costly.  Stop-losses are typically most effective with penny stocks which trade at least 10,000 shares per day and have lower price volatility.

Sometimes a penny stock may jump right past your stop-loss price. For example, shares fall in a single minute from $2.85 to $1.91 (for whatever reason), right over your mental trigger price of $2.50. This still counts as your stop-loss price being activated, and trading theory suggests you would sell immediately.

Stop-losses are the single most important tactic for any type of investing.  In penny stocks, they become even more significant.