Beware the Downside of Stop-Loss Orders

While investment advisors often recommend the use stop-loss orders as a way for investors to protect their portfolios, this strategy is not foolproof. Therefore, it is important to understand the downside risk of stop-loss orders so that you are not blindsided by an unanticipated outcome.

A stop-loss order is an order to sell a stock once it hits a predetermined price. For example, you might set a stop on shares of Company X, which is trading at $20 per share, at $17 per share, or 15% below the current price. In this instance, you are telling your broker to sell the shares if they fall to $17 or lower. The order will be executed automatically, usually by a computer, once the stop price is hit.

A stop-loss order is a market order. It does not tell your broker to sell the stock in the example above at $17 per share but at the best price available at $17 or below. As a result, while, in most instances, your order probably will be executed at $17 per share or close to it, that outcome is not guaranteed. For example, if the stock and/or the stock market are declining rapidly when your order is triggered, your trade could be executed at a price well below $17.

Here are some factors to take into account when considering how and when to use stop-loss orders.

1. Know the trading characteristics of the stock on which you are considering establishing a stop-loss. For example, consider whether the company is a large, blue chip firm whose shares trade actively and have a relatively narrow 52-week trading range versus a less seasoned, more speculative company whose share are thinly traded and often experience wide swings in price. This information can be important in deciding whether to use a stop-loss order at all and, if you do, in setting an appropriate stop price.

2. Don't set a stop-loss order and then ignore the stock. Be aware of developments at the company that may affect its near-term and long-term outlook and take appropriate action. For example, if a stock's price has traded down close to your stop-loss price due to a negative change in outlook, perhaps it would make sense to sell the shares rather than waiting for them to hit the stop-loss trigger. Alternatively, if company's prospects have improved since you established your stop-loss order and, as a result, its share price has risen, you may want to raise your stop-loss price to reflect the shares' current trading level.

3. Take into account the potential tax implications of a stock sale as a result of a stop-loss order before you place the order, so that you don't trigger an unwanted or unexpected tax liability it the trade is executed.

4. Consider using a stop-limit order rather than a stop-loss order if there is a price below which you do not want to sell the shares. A stop-limit order allows you to set a stop price at which a trade will be triggered, as well as a limit price below which the stock will not be sold.

Sources:

Mary Pilon, Karen Blumenthal and Jason Zweig, online.wsj.com, When "Stop Loss" Trades Backfire

Jonathan Burton, www.marketwatch.com, Stop-loss orders offer protection, but you may regret it Life Savings

Jonathan Hoenig, www.smartmoney.com, The Perils of Stop-Loss Orders - Investing - Stocks - Smartmoney.com