The stop-loss order has come to be regarded as an ineffective investing tool at best and a trap for the naive at worst, but the controversial tool still has its uses.
Granted, it is more complicated than the alluring name would have you believe. Stop-loss orders, which trigger a sell order once a stock declines to a certain price level, can be a dangerous instrument in the hands of those oblivious to the risks.
On May 6, 2010, North American stocks went into free fall in a market blip that wiped away billions in market value, before the losses were recovered minutes later. Many individual investors who had placed stop losses saw their stocks sell for far less than their trigger prices, just to see the securities they sold recover their former value.
"The flash crash certainly increased scrutiny," said James Stares, director of product management at Scotia iTrade.
If a stock falls hard and fast, for whatever reason, you might not be able to realize your desired price, simply because there might not be anyone willing to buy at that price.
This is where a stop-limit order, which requires an investor to set a minimum acceptable price, can help mitigate the damage.
Beyond extraordinary destabilizing events, everyday volatility should also concern investors who use stop losses. All stocks have a range through which they normally fluctuate. A stop loss set within that band could trigger a trade on what may be nothing more than a moderate, recoverable drop in share price.
Some investors make the mistake of arbitrarily setting a stop loss at something like 5 per cent below the trading value.
"That doesn't work," said Michael Bowman, portfolio manager of Wickham Investment Counsel. "It only makes sense if you put the stop in just below support." Technical indicators can help identify levels of support, at which stocks tend to bottom out. "The idea is that if the stock drops below that support, it should go lower to the next support."
That brings up another common criticism of stop losses, that investors using them miss out on the eventual recovery.
Mr. Bowman disagrees, saying: "The market always gives you another opportunity." Investors need not ride the stock all the way to the bottom in order to take advantage of a rally.
Buy-and-hold investors, who hold stable stocks over the long term and are less concerned with short-term stock movements, will have little use for stop losses, as will the full-time investor who can adjust positions in real time.
"I don't put them on bank stocks. I don't put them on pipelines," Mr. Bowman said.
Instead, the stop loss is best suited to active traders who don't constantly monitor their portfolios. A stop loss can form the basis of a rational exit plan. Investors who have seen one of their stocks take a sharp fall may cling to the hope of a recovery. By placing a stop-loss order on a stock at a specific trigger price, investors can relegate the decision to sell to a pre-determined rationale.
"That's one of the biggest challenges for investors," said Mr. Stares. "People tend to have hope, and hope is a bad thing in investing."
Steve Fryer, a self-directed, part-time trader who lives in Bolton, Ont., recently took a position in Tesla, the electric car company with a highly volatile stock that has risen almost sixfold in the past year.
"If you look at a valuation on a company like that, there's really no reason it should be worth $30-billion. But you can still make money from it. Why miss out on profits?" he said.
But he was worried about the possibility of a big correction. So he put a stop loss on the stock, which was triggered in early February when the stock fell 3.5 per cent from its intraday high, locking in a nice profit and avoiding a subsequent drop of 7 per cent in the stock, Mr. Fryer said.
"If you don't have the time, and you're not watching it constantly, you can really get hosed."