This weekend my Stockmarket Weapons and Tactics Class is underway. The classes are full of valuable information, and some of the things we really emphasize are risk tolerance, risk aversion and risk of particular strategies. Apropos of the emphasis on risk, a subscriber recently wrote asking about avoiding risk in a stock purchase. The risk in a stock purchase is actually quite high. It is the price paid for the stock. Absent any other action, whatever a trader pays for a stock is what is at risk. The stock could suffer a huge drop, even to zero and, in the latter case, the whole investment would be gone. Of course, it is relatively rare that a stock goes to zero but it does happen. More often, stocks take a big fast dive and that, too, can lead to large losses. What kinds of things can a trader do to avoid or limit losses? There are a number of possibilities to try to limit losses, and, as we shall see, none may afford complete protection.

In this article, I'll discuss the stop loss and stop limit orders as ways to attempt to limit losses. The "stop loss" or "sell stop" order is an instruction to the broker to sell the stock if it hits a certain price. Suppose I buy 100 shares of XYZ stock at $50.50 a share as it bounces off support. I will have invested $50.50 (plus commission, of course). The support is at $50 so I might place a stop loss at $49.90. That means that if the stock goes down and the price touches $49.90, my stop will have been hit and my order to sell the stock will go to the floor as a market order. As my order hits the floor, let's say the stock is down some more to $49.75. My stock is sold at that amount and my loss is fixed at 75 cents a share. Not too bad, a loss of $.75 plus commission and the stock is still falling in my example. Now, let's look at the same stock that I bought for $50.50 and placed a stop loss at the same $49.90. In this instance, however, let's say the stock closed last night for $51 and this morning, after some really bad news overnight, the stock gaps down $21 and opens this morning at $30. What happens? Well, the stock went through my stop so the stop loss order at $49.90 was activated and my order now goes to the floor as a market order and I am filled at $30. I've now lost $21 a share. Not so good, but at least I'm out and not trying to hold onto this now rabid dog.

It is important to know that a stop loss order does not offer complete protection. Even with a stop in place, the trader can still lose very significant amounts in the event of a gap down as I discussed above. On the other hand, I think that having a stop loss order in place does help to get out of many positions with relatively small losses when the trader might otherwise be tempted to hold on because he thinks "it'll come back." Placing a stop loss can help to remove emotion. If the trader decides beforehand where the stop will be placed and under what circumstances it will be moved up (never down for the stock owner), there is a lesser liklihood of staying in too long or jumping out too quickly. The stop loss is then a tool that can enhance a trader's discipline. As the stock moves up, the stop can also be moved up thereby attempting to protect profits (though the problem of a gap down always exists).

Generally, brokers do not charge to have the stop placed. A commission is charged only when the actual trade is completed. However, stop loss orders are visible to the floor and I have heard many people complain over the years that "my stop got hit and then the stock moved right up." What can a trader do about that predicament? If a trader has a broker or chart service that allows him to place alerts, he can place an alert that will be sent when the chosen price is hit. Of course, the trader needs to act then or the purpose of setting the alert is defeated.

A stop limit (as opposed to a stop loss) order is essentially a two part order. The "stop" part is the same as the stop loss in that the trader sets an amount at which an order will be sent to the floor. However, by adding the "limit" part, the trader is saying sell my stock but only if it is at the limit I set or better. Going back to the earlier example where I bought XYZ at $50.50, suppose I set a stop limit with a stop at $49.90, limit $45. That means if the stock hits $49.90 or less, I want to sell my stock at $45 or better. If the stock is above $45, all is well and good, but what if the stock did gap down to $30? In that instance, the stop would have been hit, but since I added the limit of sell at $45 or better, I will own the stock since it is trading below $45. The order did me no good in that situation. Fact is, on a drop like that, I probably just want to be out of the position. For that reason I just do not use stop limit orders though there are many times when I use stop loss orders.

Next week, I'll talk about some uses of options to reduce risk.

Good Trading!
Bill Kraft

August 26, 2006

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