How to Protect Your Profits by Using Stops
Stop Order and Stop Limit Orders
In common parlance, stop and stop limit orders are known as “stop loss” orders because speculators use them to lock in profits from profitable trades.
A stop order automatically converts into a market order when a predetermined price is reached (this is referred to as the “stop price”). At that point, the ordinary rules of market orders apply; the order is guaranteed to be executed, you simply don’t know the price – it may be higher or lower than the current price reported on the ticker symbol.
Trailing Stop Orders
One way to protect gains and limit losses automatically is by placing a trailing stop order. With a trailing stop order, you set a stop price as either a spread in points or a percentage of current market value.
Imagine you purchased 500 shares of Hershey Chocolate at $50 per share; the current price is $57. You want to lock-in at least $5 of the per share profit you’ve made but wish to continue holding the stock, hoping to benefit from any further increases. To meet your objective, you could place a trailing stop order with a stop value of $2 per share.
In practical terms, here’s what happens: Your order will sit on your broker’s books and automatically adjust upwards as the price of Hershey’s common stock increases. At the time your trailing stop order was placed, your broker knows to sell HSY if the price falls below $55 ($57 current market price - $2 trailing stop loss = $55 sale price). Imagine Hershey increases steadily to $62 per share; now, your trailing stop order has automatically kept pace and will guarantee at least a $60 sale price ($62 current stock price - $2 trailing stop value = $60 per share sale price). In other words, the trailing stop order will increase in your favor and lock in any gains you’ve made in the interim. If Hershey were to fall to $60, your trailing stop order would convert to a market order for execution, your shares would be sold, and should result in a capital gain of $10 per share.
Trailing stops, a form of stop loss orders, can also protect a profit and, if you’re clever, follow a stock’s rising price. Let me explain.
First, a quick review. A stop loss order placed with your broker is a way to protect yourself from a loss, should the stock fall. The stop loss order tells your broker to sell the stock when, and if, the stock falls to a certain price.
When the stock hits this price, the stop loss order becomes a market order. A market order instructs your broker to sell immediately at the best possible price. In a volatile market, you may not get the price you wanted, but it should be close.
Protect Your Profits
That’s how you protect yourself from a bad loss. Now, here’s how you use the stop loss order to protect your profit on a stock that’s rising.
There are two ways to enter a stop loss order. You can enter a dollar amount, for example if your stock is selling at $40 per share, you might enter a stop loss order for $37.50 per share. When the stock price drops to $37.50, it trips the stop loss order and the broker sells it.
However, what if you were fortunate enough to (through careful research) to have a growth stock that was rising on a fairly steady basis? Let me set up a scenario.
You bought the stock two years ago for $25 per share and it has grown 23% each year and is now pushing $38 per share. When you can stop patting yourself on the back, you began to get a little nervous that this run of growth might be coming to an end.
Trailing Stop
Using our example, the trailing stop would kick in at $34.20 per share ($38 x 10% = $3.80; $38 - $3.80 = $34.20).
If the stock keeps moving up, so will the trailing stop. For example:
- At $39 per share, the trailing stop is $35.51
- At $40 per share, the trailing stop is $36.00
- At $41 per share, the trailing stop is $36.90
- At $42 per share, the trailing stop is $37.80
As long as the stock keeps rising or holds relatively steady, nothing happens. However, if it turns south and hits your trailing stop, your broker sells and you pocket your profit. It is important to note, the trailing stop only goes up, it never goes down with a market price.
The trick is setting the percentage at a level that will pick up a true price drop as opposed to normal daily price fluctuations.
Conclusion
Several trading techniques use trailing stops. This example is a simple strategy to protect your profit. More advanced traders use it in combination with other maneuvers to extend their advantage. However, this strategy works just fine for beginning to intermediate investors who want to protect a profit, but let a winner run as long as possible.
Understanding Stop Loss Orders
How Stop Loss Orders can Protect You
When the bottom falls out of your favorite stock’s price a stop loss order on file with your broker can help ease the pain.
A stop loss order instructs your broker to sell when the price hits a certain point. The purpose of the stop loss is obvious – you want to get out of the stock before it falls any farther.
A stop loss order works like this: You tell your broker you want a stop loss order at a certain price on the stock. When, and if, the stock hits that price, your stop loss order becomes a market order, which means your broker sells the stock at the best market price available immediately.
Setting a Stop Loss
If the stock is trading at $30 per share and normally doesn’t fluctuate more than $1-$2, then a stop loss order at $26.50 might be reasonable.
A good example of how investors could use the stop loss order was when Merck, the pharmaceutical giant, pulled its blockbuster arthritis drug Vioxx off the market. Studies linked usage of the popular drug to an increased likelihood of heart attacks and stroke.
As soon as Merck made the announcement, its stock began dropping like a rock because investors knew how much the company was counting on profits from the drug.
Wiped Out
By the end of the day, the stock was down almost 27% or over $11 – wiping out billions in value of the company.
The stock opened around $45 the day of the announcement. If you had a stop loss order in for $40, it would have triggered very soon after the announcement.
When the market hit your $40 price, your stop loss order became a market order, meaning your broker sold the stock at the best current price. That may not have been $40.
A fast-moving market may go past your target before your broker can fill your order. The good news is you probably want out of a plunging stock at the best price you can get and will take what you can get.
You can also use stop loss orders to lock in profits keeping these things in mind:
- Be careful where you set your stop loss points. If a stock normally fluctuates 3-5 points, you don’t want to set your stop loss too close to that range or it will sell the stock on a normal downswing.
- Stop loss orders take the emotion out of a sell decision by setting a floor on the downside.
- If you plan to be out of touch from the market, on vacation for instance, put stop loss orders in so you have some protection against an unexpected disaster.
- Stop loss orders don’t guarantee against losses. When disaster strikes a stock, it may fall so fast the best you can hope for is to come out close to you price.
Conclusion
Stop loss orders are great insurance policies that cost you nothing and can save a fortune. Unless you plan to hold a stock forever, you should consider using them to protect yourself.
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Tags: capital management, Common Stock, Current Market Value, Current Stock Price, Execution, Hershey Chocolate, Interim, Limit Losses, Objective, Pace, Parlance, Profitable Trades, Profits, protect profits, risk protection, S Books, Speculators, stop, Stop Loss, Ticker Symbol, trade plan, Trading Strategies, trading system, trailing stop, Trailing Stop Loss, Trailing Stop Order
