Use Stops To Protect Yourself From Market Loss

Many investors and traders do not know how to protect their open positions in stocks, futures, and other securities. Fortunately, some simple strategies manage downside risk in both bull and bear markets. These strategies include buy stops, buy stop-limits, sell stops, and sell stop-limits. Below are some techniques investors can use to place them effectively in any type of market condition.

Sell stop and sell stop-limit orders offer two powerful methods to protect long positions. A sell stop order, often referred to as a stop-loss order, sets a command to sell a security if it hits a certain price. When the security reaches the stop price, the order executes, and shares or contracts are sold at the market. The sell stop is always placed below the security's market price. (To learn more, read The Stop-Loss Order – Make Sure You Use It.)

A sell stop-limit order sets a command to sell a security if a specific price is reached as long as the price does not fall below the limit specified by the investor or trader. When the security reaches the stop price, the order is converted into a limit order, which is executed at the specified limit price or better.

Neither order gets filled if the security does not reach the specified stop price. (To learn more, read Exit Strategies: A Key Look.)

The proper use of sell stop and sell stop-limit orders lowers risk and protects your investments, up to a point. These tools keep the decision-making process simple and unemotional, even when the market is in turmoil. They also improve risk management skills by identifying key price zones in advance and increasing the conviction needed to hold firm between those actionable levels.

There are two common methods used to place sell stops, but no magic number or formula will work 100 percent of the time. Also, stops can be raised as the security gains ground.

The first method is to place the stop below the support level. Identify a support level by looking at a chart and finding where it stopped falling during prior downturns. A break below this price often means the security will head even lower before reversing. (To learn more, read Support and Resistance Basics.)

The second method is to place the stop 5 to 15 percent below the purchase price depending on the investor's comfort level. Theoretically, at least, this lowers the likelihood of a catastrophic loss. In addition, identifying the potential downside in advance allows the investor to prepare for a worst-case scenario.

When a security falls into the sell stop price and the order is executed, this is referred to as stopping out. So, while sell stop and sell stop-limit orders keep the investor on the right side of the markets, there will be times when those stops execute just before the security reverses in the intended direction.

How can you avoid this? As a general rule, avoid placing stops at round numbers, such as 10, 40, or 100, because many market participants place stop orders at these levels and invite trouble from opportunistic algorithms and market makers. Instead, the investor can place the order at an odd number or in-between round numbers with enough wiggle room to survive a potential last round of selling pressure.

For example, if many traders place sell stops on XYZ at 35. In this scenario, consider placing the sell stop at 34.75 to provide enough room for a final round of sell orders without incurring an unnecessary loss. While the investor does not know exactly where other traders will place their stops, taking crowd behavior into consideration should decrease the likelihood that an investor will stop out during a temporary downdraft.

A buy stop or buy stop-limit order protects upside risk if a short sale position moves against the investor (goes higher in this case). Shorts sell an unowned security by borrowing shares or contracts from the broker with the goal of buying them back at a lower price to make a profit. Conversely, the short seller incurs a loss if the security rises and the short seller is forced to buy it back at a higher price. A buy stop order is used to limit the loss or to protect a profit on a short sale and is entered above the market price. The order is executed at the market if the security reaches this price. (For background reading, see the Short Selling Tutorial.)

A buy stop-limit order covers the short sale when a particular price is reached, at which point the order converts into a limit order. The buy stop-limit order will only be executed at the specified limit price or better, similar to the sell stop-limit order.

Similar to sell stop and sell stop-limit orders, placing buy stop and buy stop limit orders can be tricky. Fortunately, there are two general rules that offer useful guidance about placement:

1. The investor should place the stop above the resistance level. This is the price where a security has trouble moving higher. The investor can determine the resistance level by looking at a chart and finding where it stopped rising during prior rallies. A breakout above this price often means the security will head even higher before reversing.
2. Place the stop 5 to 15 percent above the short sale price depending on the investor's comfort level. These can also be adjusted upward to protect profits.

The same techniques used with sell stop and sell stop-limit orders can be applied to buy stop and buy stop-limit orders. These include avoiding round numbers and placing orders around odd numbers.

For example, if many short sellers place buy stops on XYZ at 35. In this scenario, consider placing the buy stop at 35.25 to provide enough room for a final round of buy orders without triggering the stop and incurring an unnecessary loss. While the investor does not know exactly where other shorts will place their stops, taking crowd behavior into consideration should decrease the likelihood that the investor will stop out during a temporary downdraft.

Traders and investors can protect themselves from volatile markets and prevent unnecessary losses by using sell stop, sell stop-limit, buy stop, and buy stop-limit orders. Investors should take the time to adapt these tools to their comfort level and risk tolerance.