Stop losing value from a declining price

March 4, 2017

background

The market value of your stock equals your principal (i.e., the amount you invested) plus any profit or loss from price fluctuation. The market price that moves below what you paid to purchase the stock will produce a loss of principal if you sell the investment. Here are several risk factors that may drive stock prices downward:

  1. Company performance. ‘Good’ companies attract investors. Conversely, ‘distressed’ companies repel investors.
  2. Industry performance. Business cycles can affect the sales of products from an entire industry. For example, sales of new automobiles declined during the Recession of 2008.
  3. Market cycles. Aside from business performance, the entire stock market is subject to periods of declining prices due to massive selloffs by investors.

The risk of an extreme loss can be prevented by setting a stop-loss price (“stop”) to sell part or all of your shares.

ways of setting the stop

The systematic way is quite simple. If the market value is below your invested principal, then select an absolute loss or a fraction of the principal. Examples:

  1. Absolute loss. Suppose you invest $5,000 in 100 shares of stock (i.e., $50/share) and you can tolerate a loss of $1,000 should the price start to fall. Regardless of future prices, you choose to stop the decline at $1,000 below the original $5,000 value. In this example, the stop would be $40/share [stop = (value – loss)/shares = ($5,000 – $1,000)/100].
  2. Fraction of value. Suppose you can tolerate a 10% loss from an investment originally valued at $5,000 for 100 shares.  Ten percent is one-tenth of 100, which is equivalent to a decimal number of 0.10. The stop would be $45/share [stop = (1.00 – decimal)*value/shares = (1.00 – 0.10)*$5,000/100].

The technical way is based on the stock’s historical prices. If you want to minimize the chance of a sale, set the stop at the lowest price from the past 5-10 years. Beware that setting the stop at a historical low may incur a steep loss. Other ways involve the more complicated analyses of trendlines, moving-average lines, or price statistics.

Another way is to adjust the price gap (gap = market price – stop) to the growth of capital gains. As the market price increases over time, choose a narrow gap to protect the capital gain or a wide gap to reduce the chance of a trade. Generally speaking, widening the price gap will reduce the chance of a trade at the risk of incurring a bigger loss.

add a limit price (“limit”) for extra protection

A brokerage firm will enforce your stop order for 30-90 days depending on the firm’s trading platform. The firm’s computer activates the order when the latest market price reaches the stop. The order is then filled at the next available price. In a chaotic market, the price could plunge below your stop to an exceptionally low value at the next available trade, resulting in a bigger loss than you planned. You might be able to prevent this result by setting a limit slightly below the stop. The trading order would be filled somewhere within the stop-limit price zone unless the transaction is cancelled, unfilled, when the next available price dips below the limit. The limit helps protect the extent of your loss.

who should worry about an extreme loss?

Nobody’s immune, but long-time investors have the least concern. Investment strategies such as dollar-cost-averaging and automatic-dividend-reinvestment plans will help protect against damages from periodic bear markets. Short- and intermediate-time investors are at greater risk for incurring an extreme loss from market down-cycles. For example, families who are saving to pay college fees or to buy a home risk big losses from a bear market.

conclusion

Stop orders are used to set the price for buying or selling exchange-traded products such as stocks, ETFs, and REITs. This article discussed the use of a stop-limit order to sell a stock in a declining market. Brokerage firms may restrict the duration of stop-limit orders to 30-90 days after which the order is cancelled without a transaction until you renew the order. Periodic renewals allow you to reconsider your strategy in light of the prevailing price trend. In a downtrend, simply renew the order. In an uptrend, you may wish to protect a growing profit by resetting the stop-limit order to higher prices. Click on this link to skimming a profit for another perspective on protecting a growing profit.

Copyright © 2017 Douglas R. Knight

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#Bracket orders

January 28, 2014

[updated the bracket order calculator on 6/25/2014.  Updated the text on 7/18/2014]

The bracket order is a trading order to buy a stock or other exchange-traded security while also placing an advanced order to sell the entire purchase at a future profit or loss.  The profit and loss exits are the brackets.  Some brokerage firms offer the bracket order to individual investors (1).  I use it to limit the loss that I might incur any time after buying the stock for a long position.  The bracket order has 4 elements: 1) Entry share price for buying the stock from the market. 2) Quantity of shares to buy. 3) Profit exit share price for selling the stock at a capital gain. 4) Stop loss exit share price for selling the stock at a limited capital loss.  Click on this link to the bracket order calculator worksheet to follow the discussion or plan your automated trade.

Taking the long position

Taking the ‘long position’ means to purchase a stock with the idea of selling it at a higher price.  But if the price falls, you suffer a loss in proportion to the size of the investment.   You can manage the risk of a loss by deciding how much money to sacrifice and using the bracket order to limit your loss.  Some investors typically plan to lose between 1% and 3% of their capital in a single trade.

Bracket order’s prices

LongPositions

The chart shows price movements for two imaginary stocks during a recent time period.  The wavy black lines are series of historical stock prices that end at the latest price on the right hand side.  Assuming that prices will continue to behave in the same way, the future prices will fluctuate between the levels of support (red dashed line) and resistance (green dashed line) until a substantial event dictates a change.  The support is the price ‘floor’ and the resistance is the price ‘ceiling’.   In between are the opportunities for profit and loss.  The ideal situation is to buy any stock near its support level and then sell near its resistance level, repeating the process over many trades to accumulate wealth.  The bracket order helps plan for these outcomes.

Suppose the latest price is suitable for investment.  Then plan to purchase the stock at approximately the latest price by placing either a market order to trade immediately at the current price or a limit order to trade at a specified or better price. Your desired purchase price is called the entry (yellow circle on the chart).   Your bail-out price is called the stop loss exit (red square), an automated order to sell the stock at a planned loss.  Your price for earning a profit is the profit exit (green square), an automated order to sell the stock for a capital gain.

Bracket order’s quantity

The final step is to calculate the quantity of shares to purchase.  The quantity is constrained to the planned loss on a per-share basis.

  • “Planned loss” is the amount of money you are willing to lose from a trade in the event of a market downturn
  • (loss/share) = entry – stop loss exit
  • quantity = planned loss / (loss/share)

The planned loss is typically less than the principal amount spent to purchase the shares (principal = entry x quantity).  You may choose to reduce the quantity in order to lower the principal.

Comments

CAUTION:  There’s no guarantee that the stop loss exit can prevent losing more than the planned loss when market prices are exceptionally volatile.  Prices typically move in small increments except in rare instances when they might plunge below the stop loss exit by several points to create a deep loss.  That’s why the SEC recently enacted “circuit breaker” rules to stop trading for any stock whose price changes sharply within a five-minute period (3).

RECOMMENDATION:  The future prices of any stock are uncertain.  Put more effort into determining the stop loss exit than in determining the profit exit by using historical prices to select a safe level of support (red square in the chart).  The profit exit reflects how quickly you want to sell for a gain; it’s better to think high and wait longer unless you’re a bonafide day trader.   Expect a longer holding period for the higher profit exit. If your brokerage firm’s trading platform allows changes, you can update the bracket order to protect gains and reduce losses as the prices rise with time.

Consider using the bracket order calculator to plan your automated trade.  If the program inspires your investing to support the betterment of society, consider making a tax-deductible contribution to your favorite charity or my favorite charity.

References

1.       Jean Folger. The pros and cons of automated trading systems.  Investopedia.com, August 24, 2011.  © 2014, Investopedia US, A Division of IAC.

2.       Investor Bulletin: New Measures to Address Market Volatility, SEC.gov, 4/9/2013.


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