- Investment Rule #3: Have an exit strategy
- To help protect your investment, consider use of the stop loss sell order
- When the stock price hits your target stop loss limit, your stock order turns into a market order
- Use it to sell your shares of stock when the price keeps going down, to avoid deeper losses
- Or use it to protect your paper gains if the share price drops to your preset stop loss limit
- Excessive stock price volatility may pose challenges to using the stop loss sell order
- We’ll show you step-by-step how to place a stop loss sell order online
Have An Exit Strategy for Your Stock Investment
Investment Rule #3: Have an Exit Strategy.
As we discussed in our Buying Stocks article, before you buy for first shares in a stock, formulate an exit strategy. Just like super spy James Bond would look for exits in case of threats when he goes into a building or a room. You need to formulate an exit strategy before you buy a stock.
In Case Your Bull Thesis Is Wrong. We would love to be right in all of our predictions, but if the stock price heads down below your buying price, how low are you willing to “stomach” the paper loss? At what point would you realize your bull thesis is not working out, and realize you need to exit the investment, even at a loss? One school of thought says you should consider selling out if it drops 10% below your purchase price. The concept is that a 10% loss is better than a 25% loss, 50% loss, 75% loss, or 100% loss. And those heavier losses all began with a 10% loss. Or you willing to cut your losses early and exit your position? Have a plan ahead of time, so you don’t get caught by surprise and be forced to make a decision when your emotions are high.
One strategy (following that school of thought above) is to place a stop loss sell order to minimize the down side risk. You would do this as soon as you buy some shares of stock. For example, if you’re prepared to sell should the stock price go south 10%, then place a stop loss sell order at 10% below your purchase price. Maybe your tolerance is not -10%, maybe it’s only -5%, or may be it’s as much as -12%, or even -15%. Whatever your tolerance, consider using this technique to protect yourself from much deeper losses.
In Case Your Bull Thesis Is Right. If you made the right call, and the share price starts to go up in price, congratulations! You’re on your way to become a successful investor.
As part of your strategy, however, consider protecting your paper gains by being willing to sell it should the price start to come back down. And you should do so before most or all of your paper gains are lost. Figure out ahead of time at what price would you head for the exit and lock in your gains? You can use the stop loss sell order to implement this strategy…
The Stop Loss Sell Order
How the Stop Loss Sell Order Works
The Stop Loss Sell Order is placed at a stop loss price that is lower than the current market price of the stock. When the stock price drops to the stop loss price (or lower) than that you had set, your order automatically turns into a Market Sell Order. As a Market Sell Order, it will fetch the next best price, which is usually a little lower than your stop loss price because the stock price is likely to continue its decline. The stop loss sell order is also known as the “stop-loss” order.
Be Careful of the Stock Price Gapping Down! The one disadvantage of the Stop Loss Sell Order is that if the stock price gaps downward upon market opening one morning, say after some terrible news, the opening price may be well below your stop price. While this triggers your Stop Loss Sell Order and turns it into a Market Sell Order, the market price may be well below your stop price – turning your sell order at a much lower price than intended. How to circumvent this, consider the Stop Limit Sell Order instead, which we discuss later in this article.
How can you use the Stop Loss Sell Order? There are a couple of ways:
Protect Your Downside Risk
Use it to automatically sell your shares of stock in case it drops below your specified stop loss price, protecting you from potentially deeper losses when the price keeps going down.
Let’s take Zoës Kitchen, Inc. (ticker symbol: ZOES) as an example. It’s a growing “fast casual” national restaurant chain that is serving fresh Mediterranean food. Yum.
Take a look at the chart below for Zoës Kitchen, Inc. Let’s say you bought ZOES in (1) in October 2016 for $22/share, expecting the share price to increase as the restaurant chain expands nationwide. Playing it safe in case things go south, (2) you placed a stop loss sell order at $20/share. So should it drop to that level, you order will automatically sell your shares at the market price, protecting you from potentially deeper losses.
But as you had hoped, it started going up in November and December to about $27/share. Hooray! But your elation is short lived, as it started descending in mid-December and continued to descend back to where you bought it, to the $22 price level. Then in late February, the stock sold off again. But (3) as soon as the price hits the $20/share stop loss price that you had set, it automatically converts your order to a sell at market price, fetching $19.97/share. It’s a loss of $2.03/share plus commission fees, about -9%. But at least you were protected from (4) further losses at it dropped to the $17.50 range by early March. Then in (5) June-July, it dropped yet again to the $12 range. So while you lost 9% of your investment, the stop loss sell order protected you from a deeper $10 loss or -45%. Sigh of relief.
Protect Your Paper Gains
If you bull thesis was right, and the stock price climbs, you can use the stop loss sell order to protect your paper gains should the share price drops to your preset stop loss price.
Let’s use Vail Resorts, Inc. (ticker symbol: MTN) as our next example. It’s a company that operates ski resorts and owns/develops related real estate properties to include Vail, Beaver Creek, Breckenridge and Keystone in Colorado; Park City in Utah; Heavenly, Northstar and Kirkwood in the Lake Tahoe area of California and Nevada; Perisher in Australia; and Whistler Blackcomb in Canada.
Let’s say you bought shares of MTN (1) in January 2017 for $163/share expecting the share price to increase as the ski season runs its course and the company expands its holdings of premiere ski resorts. As the price climbs, steadily up like a ski lift taking skiers up the side of a mountain, (2) you placed a stop loss sell order in April at $180 to protect your small paper profit, in case there were any downside surprises like a disappointing earnings announcement.
But fortunately, the share price continued to ratchet upward. In May, you (3) increased the stop loss sell order price from $180 to $190, protecting your increased paper profit. Amazingly, this cycle continues, as if Vail Resorts is selling ice to the Eskimos. So in August, (4) you raised the stop loss sell order price yet again to $200, then ratcheted it up to $215 in September as it traded around $230. Should the shares dip to $215, the stop loss sell order will automatically convert to a market sell order, and fetch you a price of about $214.95. That’s a handsome 32% capital gain. Nice!
Placing the Stop Loss Sell Order Online: A Step-By-Step Guide
The following instructions are for Schwab One brokerage account. Why Schwab One? Because we recommend the Schwab Bank account, and you get a linked Schwab One brokerage account when you open the bank account. Open both accounts and fund your Schwab One brokerage account with $1000 and get a $100 bonus, using our referral.
In any case, other brokers have similar buy order formats. We highlight the differences below.
Step 1. Login to your brokerage account.
Step 2. Under the tab “Trade”, under the “Stocks & ETFs” heading, choose “Trade Stocks”.
Step 3. In the Symbol text field: enter the stock ticker symbol. We use Activision Blizzard Inc. (ticker symbol: ATVI), the maker of video games for PC, gaming consoles and mobile devices, as our example. See screenshot below…
Step 4: Verify your position, the number of shares you have in your account, as displayed under the ticker symbol right after completing Step 3. In our screenshot example, we are holding 99 shares of ATVI stock.
Step 5: Review the real-time quote. ATVI last traded at $64.51.
Step 6. Under Action, select “Sell”.
Step 7. For Quantity, enter the number of shares you want to buy, in whole numbers (no decimals). Be sure to confirm this against quantity of shares that you have in the account. It should be equal to your total holdings or less, if you want to still hold a position in the stock. Do not sell more than the number of shares that you are holding. That would be considered short selling. Schwab warns you should you enter a quantity greater than that you’re holding.
Step 8. Under Order Type, select “Stop”. You will get another field…
Step 9. Enter the stop price in dollars and cents, using decimal. We entered $60.00, meaning the Stop Loss Sell Order will automatically turn into a market sell order should the price drop to or below $60.00.
Step 10. Under Timing, choose “Day Order” or “Good Until Canceled” (also known as Good-Till-Canceled, GTC). For a Stop Loss Sell Order, you want it to take effect until you cancel it. Schwab One brokerage defaults the duration of the Good Until Canceled option to 60 days. You cannot change the end date. But you can cancel the limit order altogether at any time from the Order Status screen. See Order Status screen graphic below (fourth graphic below).
Other brokers, like TD Ameritrade, allow you to go up to 90 days, with the end date specifiable by the user.
Step 11: Expand Option to show the All-or-None checkbox. We did not check it in this example for ATVI, because the minimum number of shares this option is applicable is 200 shares. We’re selling only 99 shares.
Different brokers have different requirements that you have a minimum number of shares before you can have the option for All-or-None. Schwab is 200 shares, while E*Trade has a minimum of 300 shares before you can use the All-or-None option.
Step 12. Confirm the Cost Basis Method as “First In, First Out” for tax purposes. If you buy and sell shares of stock in different lots, this gives you options to help with the gain/loss tax accounting by the brokerage. Ultimately though, the tax filing and methodology is your responsibility.
Step 13. Check the order total. This is the amount before the trade commission.
Step 14. Click on the button “Review Order”. The next page will summarize the order, before you commit to the trade.
Step 15. The next page summarizes the order. Be sure to review your order parameters: the stock ticker symbol (ATVI), action (Sell), quantity (99 shares), order type (stop at $60.00/share), timing (Good Until Canceled), and Cost Basis Method (First In, First Out).
Step 16. Check the total amount, with trade commission (Schwab charges $4.95).
Step 17. When all fields are acceptable, click on the “Place Order” button to submit your order to the stock exchange.
Step 18. You will get an Order Received screen, showing you the order parameters. The same info as that you just verified in Step 15. It will display the order number for your reference/record keeping.
Step 19: From here, click on “Order Status” link to see the results of your stock trade order.
What Happens Next: Trade Execution, Or Not
To check your order status, login in Schwab One brokerage account. Then pull down the tab “Trade”, under the “Order Status” heading, choose “All Orders”. The following Order Status screen displays.
When the order is placed, but the trade has not been executed, it is called an “open” order. When the order executes, its status is considered “filled”.
When your order is still “open”, you can choose to change your order, adjusting the stop loss price as your needs change. Reference the “ratcheting” up the stop loss price technique as described in our Vail Resorts example above.
The Stop Limit Sell Order
There is yet another option. The Stop Limit Sell Order is similar to the Stop Loss Sell Order that we had discussed up until this point.
How the Stop Limit Sell Order Works: Like the Stop Loss Sell Order, the Stop Limit Sell Order is also placed at a stop price that is lower than the current market price of the stock. When the stock price drops to the stop price (or lower) than that you had set, your sell order turns into a limit sell order (instead of turning into a market sell order as in the stop loss order). So, instead of selling at the market price, it sells at the limit price that you specify, usually higher than the stop price. In this case, the stop limit sell order is a conditional order, as it would only execute if the stock price declined to your stop price, then recovered to your limit sell price. It is also known as the “stop-limit” order.
Placing the Stop Limit Sell Order Online: A Step-By-Step Guide
The steps are the same as the Stop Loss Sell Order described above, with one addition after Step 9, which we will call Step 9B as follows:
Step 9B. Enter the limit price in dollars and cents, using decimal. We entered $61.00 as limit price.
When the stock price drops to $60 or lower, the Stop Loss Sell Order is triggered, automatically turning itself into a Limit Sell Order, with a limit of $61.00. The stock price would have to climb back to $61 or above, before the Limit Sell Order is filled. In this way, you would protect yourself from selling too low, but your order may not fill if the stock price continues to go down after triggering the stop of $60.
You can set the limit price at any price relative to the stop price. It can be lower, the same, or higher (as in our example above).
Excessive Volatility and the Stop Loss or Stop Limit Sell Order
As you know, not all stocks appreciate the same way… some grow steadily, with low volatility. Almost like a ski lift taking skiers up the mountain. Vail Resorts, Inc. (ticker: MTN) is one example of these steady climbers.
On the other hand, other stocks may grow, but in spits and spurts, with major pull-backs. Advanced Micro Devices, Inc. (ticker: AMD) is one of those stocks.
When the stock has excessive volatility, a stop loss sell order might easily trigger and “shake you out” of your shares of stock prematurely. This is bad, if the stock eventually climbs higher as per your bull thesis. For this reason, you should:
- Buy on a dip: and getting in at a lower price point minimizes the amount of price drop that you would have to endure. This serves better for your peace of mind, and minimizes the chance that a stop loss sell order could take you out of the market prematurely.
- Consider not using the stop loss or stop limit sell order: Just tolerate the volatility, while you still believe in your bull thesis.
Tools of the Trade
The stop loss and stop limit sell orders are tools for the stock investor. They’re Tools of the Trade, if you will. As with all tools, you have decide when it is appropriate to use a particular tool. Or just leaving them in the toolbox, knowing that they’re available if the right occasion arises.