A stop loss is an agreement between an investor and their broker. It tells the broker to sell certain shares if they fall to a pre-set level. This protects the investor from heavy losses – and locks in any established profits.
If an investor buys shares in ABC Plc at 100p, it is wise to set a stop loss at 75p, representing a maximum loss of 25% on the investment. It doesn’t matter if the investor is away on vacation, the stop loss will automatically trigger when the stock hits 75p, and the broker will sell the shares in the open market at the best available price.
Imagine the investor bought shares at 100p, and the price increased to 150p, providing a 50% gain. The safest thing to do (assuming they are not ready to take profits) is to increase the stop loss. So, 25% below the current price of 150p is 112.5p, which is the new trailing stop loss level. Should the price fall back, the investor has still saved at least a small portion of their profit, and all of their original investment.
Indeed, while a stop loss helps protect the investor from heavy losses, it is not 100% guaranteed to be implemented. For instance, if a pharmaceutical company pulls one of its flagship drugs from the market overnight, the market makers will mark down the opening stock price the next morning. This gives brokers no opportunity to fulfil stop loss orders.
Similarly, a market may fall rapidly during trading hours. When there are only sell orders being made, the price of a stock will continue to fall. This makes it difficult to sell at a good price, and the broker will have to take whatever price they can get.
When setting a stop loss, remember that the stock needs room to breathe. It is normal for stocks to fluctuate a little, even when the overall trend is positive. For instance, if XYZ Plc is purchased at 50p, and the stop loss is set just 10% lower at 45p, it is possible that the investment will be stopped out before it even has a chance to get going. Although 25% is a fairly arbitrary amount, it does allow for modest price fluctuations while still protecting the bulk of the investment.
Automatic stop losses are good because they take all the emotion out of making a sell decision. Amateur investors often make the mistake of holding on to doomed stocks because they still believe the upside potential holds true. But if the stock is in a downward momentum, the smart decision is to limit the loss and buy back in later if and when the stock bounces back.