Investors worried about a plunging stock market can hit the brakes automatically by selling shares when a pre-set price is reached, avoiding deeper losses.
This option, a stop-loss order, may look especially appealing in the wake of the market's recent gyrations. But some experts warn it is best for experienced traders and might backfire on ordinary investors who are better off with routine strategies like simply waiting out the downturns.
"A stop-loss order is a trading tool, and trading and investing are entirely different," says Dejan Ilijevski, president of Sabela Capital Markets in Munster, Indiana.
Not everyone sees it that way, though.
"Certainly stop-loss orders are a prudent investment strategy for ordinary investors, not just short-term traders," says James F. Lubin, chief executive officer at Beacon Hill Private Wealth Management in Woodbury, New York.
Stop-loss orders are used with stocks, and with funds that are traded like stocks, such as exchange-traded funds and real estate investment trusts. They can't be used with ordinary mutual funds because those are traded only once a day at the price set after the markets close.
With a typical online trading site, the investor calls up a sell order and then specifies it be a stop-loss order rather than a more common market order. Market orders sell the security at the current trading price when the order is filled, while stop-loss orders sell only when the price has fallen to a level the investor has specified. Usually, a stop-loss is a day order good for that day, or a good-until-canceled order that lasts until the target price is reached or the investor rescinds the order.
If XYZ Corp. was trading at $100 a share, you could issue a stop loss to sell at $90 and feel like a winner if it fell to $80.
One benefit, experts say, is the stop-loss order is put in during a rational moment, helping the investor avoid a panicky move when prices fall.
"Stop-loss orders take the emotion out of the decision process," says Jay Srivatsa, CEO at Future Wealth in Los Gatos, California. "We put stop-loss orders for clients based on their risk threshold and don't react to day-to-day declines."
Still, many experts warn against using stop-loss orders as a crutch, arguing it's just too hard to predict market ups and downs, and too easy to miss gains by staying on the sidelines.
"We would not recommend stop-loss orders in 2019," says Michael Osteen, chief investment strategist at Port Wren Capital in Beaufort, South Carolina. "We believe you will see more up and down volatility swings. As such, using them would reduce your overall gains provided you are a long-term investor."
Investors should consider these points before going employing stop-loss tactics:
-- Is it really needed?
-- Decide how much to sell
-- Name your price
-- Should you add a limit?
-- Weigh the alternatives
Do you need it, really? Stop-loss orders have been around for a long time, but may not be quite as valuable now that investors can trade online or with their phones and don't have to contact a live broker. You can set a phone app to alert you when prices are falling, then order a sale, so it's not quite as important to issue an order ahead of time. Long-term investors focused on college and retirement generally don't need to turn on a dime, anyway.
How much to dump. You don't have to sell every share, of course. You could hedge by selling half at a 10 percent drop, and keep the rest to ride things out, and hope to buy back if the price falls further. You could sell more if the price keeps falling.
What's your sale price? Setting the stop-loss trigger point takes a lot of thinking. Set it too high and you might end up selling on a routine dip and missing a rebound. Set it too low and you'll take a big loss before getting out.
"Determining an appropriate loss level can vary greatly among investors," Lubin says. "For some, 10 percent to 25 percent might be a comfortable risk tolerance. However, for buy-and-hold investors, their strategy might not include using any stop-loss. In fact, such investors may look to increase their exposure to a position on a meaningful decline, particularly if the investor has a long-term time horizon."
Experts say it's also important to have a plan for the proceeds before issuing the sell order. Will you hold the cash to buy shares back at a lower price? If the price rebounds, will you be willing to buy back for more than you got in the sale? Will you use the cash for something else?
Add a limit? A "limit" can be added to the order to assure the sale does not take place below your target price in a plunging market if the trade can't be done at the price you want. But if there's no buyer at the limit price there will be no sale at all, and you could be stuck with the shares as their value plunges.
"Stop-loss limit orders can be tricky to employ," Lubin says. "If you have determined a stop-loss order is appropriate for a certain position, including a price limit may prevent the order from being executed."
What are the alternatives? The most obvious is to just hang in there, waiting for prices to recover. The broad market has always rebounded, so it's a pretty safe bet if you can afford to wait. Individual stocks and funds can be hammered too badly to ever recover, making the stop-loss a step to consider.
But if your portfolio is packed with vulnerable holdings, switching to a safer mix might be better than resorting to tricks to cut your losses.
"If you are worried about market drops to the point of thinking about stop-loss triggers, then think about reducing your portfolio risk exposure instead," Ilijevski says.
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