Stop Using Stop Orders

Traders often use stop-loss orders when they hold shares that they think will go higher, but worry will go lower. The purpose of the technique is to limit losses.

The stop-loss order sets instructions sell the stock if it drops below a specified price. There are several types of stop loss orders. A stop-sell converts instantly to a ‘market’ order when triggered by the price dropping below the specified price. The 'sell-limit’ or 'stop-limit' puts a limit on the sell order – it activates when the stock drops to specified price, but will not be executed if the stop gaps down below the set price.

There are also fixed price stop losses (e.g. sell at $670) vs. trailing stop losses (sell if the stock drops more than x% from where it has been trading). The trailing stops allows the set price to move up as the share price rises.

See video: Stop Using STOP Orders – By Paul Price

Generic example: We own 100 XYZ shares which now trade at $50.

To protect against a large loss, we enter a stop-loss (or "stop-sell") at $45 (10% below the present quote).
If XYZ declines to $45, our order triggers automatically and becomes a market order to sell 100 XYZ.
Our upside is unlimited as long as XYZ does not drop to $45.

In theory we wouldn't give back more than 10% before exiting. However, in practice, a gap-down opening below the trigger price would trigger a market sell order and we might sell for less than $45.

A stop-limit set at $45 would prevent the shares from being sold for less than $45. In that gap-down scenario, the sale would not be triggered if the shares opened below $45 and never bounced back.

Real example: Priceline [PCLN] in August, 2012.

You have a big gain in PCLN which is trading at $680 per share. To protect your gain, you enter a stop-loss order on your shares.

The outcome of PCLN falling on August 8, 12, depends on the type of stop-loss you entered. If you put in a 6% trailing stop-sell order (market) when PCLN was quoted at $680, it would have triggered on a $40.80 drop to $639.20 or below.

PCLN opened at $575.10. Your stop-loss order morphed into a market order and forced you to sell at $575.10. That locked in a $104.90 hit from the previous day’s close.

Suppose you understood the distinction and ‘wisely’ put in a stop-limit at that $639.20 (-6%) level. Your stop-limit order would have activated, but you wouldn’t have sold at $575.10 or less. Your now-open order would be live but unexecuted, awaiting a rebound of more than 11% to get back to the limit $639.20 price.

Priceline closed at $562.32 without much intraday bouncing. So…you’d still be long PCLN with a one-day paper loss of $117.48 or (-17.28%).

Whether you used a stop-sell (market order) or a stop-limit order, your trade went badly.

Two ways could have reduced or eliminated risk:

1. You could have bought PCLN put option(s) as a form of insurance.

2. You could have sold your shares at $680 on Tuesday before the big selloff.

Everything works sometimes. Nothing works every time.