Stop Orders: Protect Yourself from Financial Cliffs

Stop orders help you avoid this
Stop Orders can help you get off this ride early.

The general philosophy of most dividend investors is that once a quality company is bought, it should be held for years, decades, or, as Buffet has famously said, forever. (Notice that forever is his favourite holding period. He didn’t say that he never sells; occasionally, circumstances dictate that stocks should be sold.)

Market gyrations are part of the game, but occasionally, market or personal circumstances may dictate that you don’t want to wait out a price recovery after a drop. The best way to dodge that bullet is to sell before the stock price falls too far.

Unlike Buffet, I am not a professional investor. I don’t spend my life devoted to evaluating companies and making decisions based on my own unique insight. I also can’t spend hours per day watching, analysing, and dissecting the markets. Even so, there are times when I start to ask myself if it’s time to get out of the pool. Many investors, whether to take advantage of a recent run-up, or in anticipation of a potential precipitous drop, wonder if they should sell. For most of us, this kind of uncertainty isn’t a lot of fun. If, like me, you don’t watch the markets closely, a lot can happen while you’re away. By the time you realize that your fears of a price fall have come to pass, it’s often too late. The good news (and the point of this article) is that there is a way to automate the selling of shares before they fall too far, even if you’re not glued to your computer all day.

 Stop orders: your always-on market watcher

A stop order is an order that an investor places with his broker. (In my case, my online broker.) If I’m worried that a stock is going to fall, but I’m not sure enough to sell, I can place this kind of order, and if the current price falls below that level, a sell is triggered, and my shares will be sold into the market. (It’s also possible to buy on a stop order, but we’re going to keep it simple at this point.)

By way of an example, if I bought stock ABC at $5, and it appreciated to, say $10, I have a choice to make. In my case, I would have bought the stock for its dividend, and so Plan A would be to ignore the price, and to carry on collecting the dividends as originally planned. Then again, maybe I don’t want to look a gift horse in the mouth. Maybe I get tempted into Plan B: to realize that I got lucky, and to cash out with a fistful of cash.

If I continue with Plan A – collecting the dividends, then this article comes to an abrupt halt right here: continue holding the stock, and carry on as before.

If, other the other hand, I decide that I want to take advantage of my good fortune and follow Plan B, I have another choice to make: sell now, and look for another investment, or hang onto my stocks as long as the price remains high, and continue to collect the dividends; in other words, sell only if the price starts to fall. The “danger” with this course is action is that, should the stock fall before I can act, I would lose some or all of the price gains I’m trying to capture.

A stop order lets me have my cake and eat it too. By placing this kind of order, I hold onto my shares, and continue to collect my dividends. The shares only get sold if the price declines to a level that I decide. To continue with the earlier example, I could choose to sell the shares only if the price declines below, say, $9. As long as the stock stays at $9 or above, I can collect my dividends, which, again, was my original plan when I bought the shares in the first place.

If the price of the shares declines below $9, the shares will be sold into the market, and I will still benefit by getting most of the run-up of the price from $5, where I bought the stock, to $10, where I placed the stop order. (I hope that the logic behind placing a stop order below the current market price is obvious. If I set the trigger price at current the current market price, I should just sell the shares directly, and forget about the extra step of the stop order.)

There are a few things you should know before you place your first stop order:

a) Your stocks will be sold at the market price. In other words, you are not guaranteed your trigger price ($9 in this example). The price may fall much further, and, once this order has been placed, your stocks will be sold at the market price, whatever that price is. If the price falls all the way to $8.50 (or further), then that is the price you will get.

b) Sometimes, stock prices “gap down” overnight, and you can be hit even harder. If the stock closes and $9.25, and bad news comes out after the close of trading, it is possible that the stock could open much lower, say, $8 or even $7 the next morning. Your sell will be triggered, and your shares will be sold at the current market price.

c) Because of points a) and b), some brokers (including mine) require that you enter a “stop limit” up to 20% lower than your stop order. This means that if the market price goes down by more than the percentage you’ve indicated, your shares will not be sold. This eliminates the possibility of having all of your shares sold at a price that is significantly lower than where you’re intending to sell. (This protection was instituted after the “flash crash” of 2010.)

d) This technique is being introduced for people who don’t or who can’t watch the markets closely. Unwatched, a stock may just as easily go up as down. If stock ABC continues its climb all the way to $15, having a stop order at $8 no longer makes as much sense as it did when the order was first placed. I will share a way to deal with this problem soon.

e) I have called this a “stop” order but many people refer to is as a “stop-loss” order, because it is often used to get out of a position before things get too bad. The term stop order is more general, and can be used for situations other than trying to avoid a loss.

f) These orders are not quite “set and forget.” They eventually expire. The amount of time this takes can vary, so be sure to pay attention when you’re placing the order.

While this kind of order certainly doesn’t remove market risk, it can mitigate it by limiting the damage caused by rapidly falling prices. The great part is that it will do this without you having to check your investments several times per day. Not a bad deal, all in all!

 

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