The Basics of Stop-Loss Investing

August 22, 2021

Your stocks are down and your stress level is high. But, whether you should sell or ride it out depends on a number of different factors. Cutting your losses short can save you in the long-run, or it could not. It’s questions like these that so-called stop-loss orders are designed to address.

What is a Stop-Loss Order?

At a very high level, a stop-loss (aka, a “stop”) is an order that an investors places with their broker to automatically sell an investment when it reaches a certain price, typically a lower price than where they bought it. These kinds of orders are intended to limit the potential loss on a position when the price starts to fall.

Most of the time, stop-losses are associated with long positions as a type of insurance against cascading losses, but these techniques can also be used to protect a short position. In that case, however, the stop will trigger if the price rises above a predetermined price.

But there are a lot of variables to consider when setting up a stop-loss order. For one thing, setting a stop to kick in as a price falls effectively locks in your losses on that trade, rather than giving your investment time to regroup and start rising again. It does protect you from a rapid fall, but locks you out of any potential upside later on.

Should You Use Stops or Not?

It’s a personal choice, and is something that some investors prefer over others, but here is what to consider when using stops.

  • Don’t sell a stock just because it’s down. Selling low in a panic is a surefire way to lose money on the stock market. As mentioned, you’re locking in your losses.
  • Research, research, and research. Don’t take any investment decision lightly. Then, once your money is on the table, keeps tabs on what’s happening with the companies you’ve invested in. Make note of leadership changes, product launches, and other events that could impact the value of your share in the company. Those are the material changes that underlie the stock price, and any changes there will have long-term implications for your investment.
  • Consider how the price of a stock has changed in the current market. Is the stock being affected by a headline and a scandal that will likely blow over? Or, is the company facing fierce competition from new and interesting technologies? If you have the sense that the landscape is fundamentally changing from when you first purchased the stock, it’s likely time to sell and a stop-loss is a good way to protect yourself from loss without limiting any short-term upside.
  • Check your price target. Many investors set a price target for when they hope to sell a stock about the time that they buy. Upon a loss, determine whether you think it’s possible for the stock to reach that price target yet at some future time. A stop-loss can limit your downside while you wait to reach that target.
  • Diversify your portfolio with stocks in differently sized companies. Small, medium, and large companies each perform differently at different points in the business cycle. In addition to diversifying your portfolio with bonds and commodities, select stocks in companies of different sizes as a way to limit your losses without resorting to stop-losses.
  • Keep your emotions in check. Although losing money can feel devastating, keep things in perspective. Even if you do lose money, if you’ve invested wisely, you shouldn’t lose everything. Keeping a cool head will help prevent rash decisions you might regret later.
  • Consider capital loss deductions a silver lining. Although no one likes to lose in the market, remember that you may be eligible for capital loss deductions on your taxes if you decide to sell at a loss. There are some restrictions, including the wash sale rule, which says that if you if you sell stock for a loss and buy it back within 30 days before or after the loss-sale date, the loss cannot be immediately claimed for tax purposes.

But, whatever the case, remember that your loss isn’t permanent and that there are advantages to taking an investment loss sometimes.

Stop-losses aren’t perfect and there are plenty of pros and cons to using them, but for investors looking to protect their principal while remaining invested in the market as long as possible, they’re worth considering.

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