There are many different strategies to use to protect your capital but stop loss limits seem to be one of the most popular. In effect this takes away any decision once a stock hits a particular level and, if the strategy is followed, you simply hit the button and sell. So, do stop loss limits work?
Market volatility
Whether you hold a stock which has the best potential in the world, if markets are volatile and outside influences come into play, then all stock prices will be affected. If we look at the mortgage crisis in 2008, which led to a worldwide depression, this impacted all stock prices no matter their potential for the future. There is one danger of using stop loss limits, the chance that maybe market volatility is short-term and you could sell before the bounce.
Alternatively, as all stocks are marked down in a prolonged period of market volatility and uncertainty, you may be able to protect your capital by selling at your stop loss limit and perhaps buying back lower down. So, there are two ways to look at stop loss limits when looking at general market volatility.
Ignore long-term prospects
If you look to use a stop loss limit strategy then you need to ignore the long-term prospects of a company if the share price falls. We can all find a reason to keep our favourite stock, perhaps the long-term growth prospects are still in place and the recent share price fall is just profit-taking. The fact is, as we touched on above, if you use a stop loss limit you need to take out the emotion in deciding when to sell a share. These limits are more often used by short-term traders who are looking to buy into momentum and sell at the first sign this momentum may be weakening. If you are playing the “momentum game” then stop loss limits can help to protect any gains you have made.
Adjusting your stop loss limit
If for example you buy a stock at $10 a share and have a nine dollars a share stop loss limit, at which point you will bailout with no questions, what do you do if the share price goes to $20? The sensible thing is to increase your stop loss limit but not by the same multiple as the share price. It may be sensible to move it up to $12 or $13 (or even higher if you want to protect your profit). This is because the likelihood is the share price will retract from a sudden rise when profit takers come in. If your stop loss limit follows the share price too closely then you could bailout on short-term profit taking, just before new buyers come in.
However, what’s the worst that can happen? You bank a significant profit, you live to fight another day and you experience the feelgood factor of successful investing.
Conclusion
Stop loss limits tend to work better for short-term traders who are literally in there for momentum and once the momentum begins to wane they want to bail out and secure their profit. Many people also use stop loss limits for long-term investments although, as we touched on above, if you do use this strategy you need to ignore your emotions and your personal feelings about an individual share and “just do it”.