How stop loss investing can save you money

Like many investors who (perhaps foolishly) invest a portion of their funds into individual shares, I’ve an ambivalent relationship to stop loss investing strategies.

If a stop loss ‘did what it said on the tin’, I’d have no complaints.

Who wouldn’t want to Stop Losses when investing? It sounds like Nirvana, a one-way ticket to profits.

But what setting a stop loss order really does is guarantee you lock in a loss if it’s triggered.

You do stop further losses from holding that share, but by exiting the position you also guarantee you won’t benefit should the stock subsequently rebound.

This post will explain the good stuff: how a stop loss investing strategy can save you money, particularly if you’re a short-term trader.

In part two, I’ll explain why I seldom set stop loss orders myself.

Stop loss investing 101

A stop loss order is an instruction to sell your holding in a stock or other security if it falls to a particular price. You literally ‘stop more losses’ by selling your position before the price falls further.

The stop loss level is a nominal value; sell the S&P index at 800, say, or sell shares in BP at £3.95 a share.

Short-term traders usually set stop losses after studying a stock’s chart of historical price movements for levels where they believe there has previously been support from buyers.

The theory (which I only buy into in the most vanilla incarnation) is that if the price drops below that, it will likely keep falling to the next support level.

More fundamental investors who don’t give too much credibility to charts (that’s me!) more typically set a stop loss as corresponding to a certain percentage fall in the purchase price. Like this, the stop loss is being used more as a risk management tool.

For instance, you might buy BP shares for £4, and decide to set a stop loss to sell if the stock price falls by 25% or more. Your stop loss level is therefore £3.

• If you buy £4,000 of BP shares for £4 with a stop loss at £3, then the most you’d expect to lose would be £1,000.

How you set up a stop loss

Stop losses are almost always orders given to brokers, generally these days via your online broking account or a spread betting account. They are usually set when the position is initially opened and the share, index, or other financial instrument first bought.

Stop loss orders are free to set; you pay your normal dealing fee when the stop loss order is executed.

A stop loss can also be a mental discipline you follow: You vow to sell your shares should their price fall below your stop loss level.

There are several dangers with such a manual stop loss investing system, however:

• You may not be watching the market when the stock falls
• You may lack the conviction to sell in the heat of the moment
• The market may move too quickly for you to sell fast enough

The third danger is also a factor with automated stop-loss orders.

A stock price may ‘gap’ down to a lower price below your stop loss, particularly when the market opens for a new day’s trading, or on sudden bad news.

In this case, your dealer may not be able to sell your holding at your stop loss price and sells at the lower price, leading to a bigger loss than you expected when you originally set your order.

To avoid this problem, some dealers, particularly spread betting companies, offer guaranteed stops, which will always honour the price you originally set when selling a share that has triggered a stop loss, even if the share ‘gaps’ down below it

Such guaranteed stop losses are not free to set, but the insurance they offer may be prudent if you’re leveraging via spreadbetting to a degree that would cause serious financial damage in the event of a sudden sharp fall.

Another kind of stop loss is a ‘trailing’ stop loss. Here the stop loss price follows the price upwards, but then comes into effect at a pre-set level below the new higher level if the price subsequently falls.

The idea of a trailing stop loss is to catch more of the upside of holding a rising security, while still protecting your downside.

How stop losses can save you money

The number one benefit of stop losses is they force you to be disciplined about your trading.

If you’re going to hold individual shares rather than more sensibly investing into a passive index tracker, you need to consider every tool to try to fashion an edge against the market.

Falling share prices are painful as we’ve all learned again in this recent bear market, yet individual decliners can and do frequently occur in bullish times when it seems everything else is rising, making stop losses even more useful in normal market conditions.

Short-term share traders typically believe that falling share prices indicate:

• An unstated problem with the company that is apparent in the downward ‘price action’, through the selling of a few better informed traders; and/or,

• Market sentiment is against the share, for whatever reason, and it’d be better to sell and wait until the share price is trending upwards.

Both theories have some validity, especially when trading small-cap shares where frustratingly often you’ll see a share price falls ahead of bad news, even though no insider dealing is ever officially investigated.

Go further than that and you enter the murky world of charting and advanced technical trading, which I’m both unqualified to discuss and highly skeptical about.

Stop losses as a portfolio management tool

I’ve found stop losses of most benefit when investing in generally rising markets, when I’ve used them as a discipline to cut bad positions (perhaps opened on faulty logic) to recycle money into better ideas.

This is particularly useful in the context of portfolio diversification.

When using stop losses as a portfolio management tool, you size each of your investments sensibly according to principles of risk/return, and set the stop loss calmly and rationally when the reasons for investing in the share are still fresh in your mind.

Then, if shares you hold in the oil major BP are plunging because a man on the news claims to have invented nuclear fusion, there’s no danger you’ll be overwhelmed by emotion or confusion. You simply follow your system, probably automatically as your dealer closes you out of the falling share.

• Say you have £50,000 to invest in 10 individual companies. You might decide to put £5,000 in each share, and set a stop loss of 20%. Like this, you are limiting the risks of any particular idea going too badly wrong.

The alternative method – to invest in shares without a selling discipline – could see the wiping out of one of your shares greatly reducing your returns.

Even worse, you could sell other winning shares to top up your position in the falling share, reducing portfolio diversification even as you chase down the loser.

One of the few concrete rules of active investing in shares is it’s better to run your winners and cut your losses, than to do the opposite. Winning shares can double, triple or go up ten times over the years. It’s vital not to sell winners too early, yet that’s what most active investors do.

Stop losses aren’t a no-brainer

For all their perceived benefits, as a longer-term investor in individual shares I rarely use stop losses myself.

I think they’re best used by very active traders who will only hold shares for a few days or even hours, and who trade for a few percentage points of upside before exiting their position, rather than those of us hoping for long-term gains.

For such buy-and-hold investors, stop losses can damage your wealth. In part two of this article I’ll explain why, so stick around to catch that post next week.