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Pros and Cons of Stop Losses

Keeping Gains and Preventing Disaster in Stock Trading

A review of whether stop loss orders are a good or bad strategy for improving stock investment performance.

Stock traders have choices when purchasing or selling a stock. Market orders are made to buy or sell a stock at the current price. Stop and limit orders are filled when a stock reaches a price selected by the buyer or seller.

Stop orders can be used for both the purchase and sale of a stock. For selling a stock, a stop order will fill if the price drops to the stop price. Stop orders can be set for a trading day or until remain good until cancelled.

An example will be used throughout this article to illustrate the principle. For instance, if a stock price is currently $40, a stop order can be placed for any amount less than $40.

If a stop order is placed at the price of $35, the stock will be sold if the price drops to $35 or lower. If the price remains above $35, the stock is not sold.
Positives of Stop Loss Orders

* Stop orders can help prevent larger losses in stock trading, in situations where the trader is not able to constantly follow the market. In the example above, a sale at $35 will limit the loss to $5, even if the price later drops to $30.
* Stop losses can also be used to hold onto gains. If the $40 stock rises to $50, a stop price of $45 can be set, in an attempt to keep the $5 gain. Stop orders can be changed or cancelled if they have not been filled. If the price continues to rise to $55, the stop price can also be reset to increase the size of the potential gain.

Negatives of Stop Loss Orders

* Stock prices are volatile, and fluctuate minute to minute. In the example, if the price drops to $35, the order is filled. The loss of $5 is locked in, even if the price recovers in a short time.
* Commissions are charged in the same manner as a market transaction.
* Instead of setting a stop loss at $35, the investor can sell the stock at the current higher price, and make a decision to purchase another investment or this stock at a later time.
* Stop orders do not guarantee that the stock will be sold at the stop price. If the stock “gaps down”, that is, the opening price is lower by a substantial amount than the prior closing price, the stop order will be filled. If the sales price, or “ask”, drops immediately to $20, that is the price at which the stock will be sold, locking in a loss of $20.

Should Investors use Stop Losses?

Although in some cases stop loss orders can prevent devastating losses, most investors should avoid using them. Frequent buying and selling increases commission cost, and stop losses are not completely effective in eliminating disastrous damages in sharply falling investments.


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