Using stop loss orders seem to be a way to lower risk when you are highly exposed to the stock market. I understand selecting the stop price is very important. And ,that with a rapid drop you probably will not get your stop price. I usually have a few stops in and have been satisfied with the results. Of course I have had some where the stop is executed ,then the stock goes up several percent. This is all in an IRA so there are not tax consequences to selling. And no fees.
Stop orders can be used for entry or exit and to protect an unrealized gain or minimize a loss.
In broad terms, its usefulness depends on who you are. A value or growth investor is likely to have little use for stop orders since for the most part, their outlook tends to be buy and hold.
For traders, trading capital is their lifeblood and it must be protected. Risk management is their key to survival. One of the oldest market clichés is “Cut Your Losses and Let Your Profits Run”. Stop loss orders are an integral tool for achieving this. They have their advantages and disadvantages but that's another discussion.
While I recognize the usefulness of stop loss orders for trading, I don't use them because I hedge my large equity positions. The hedging is a built in hard stop that avoids the surprise loss of a large gap up or down through the stop's price or a concerted move against my positions like the market's 35% down move in March.
If you own stock XYZ (not a real stock) and it goes down is that a reason to sell? If you view the price of a stock to be a random walk, the fact it has gone down does not mean the pattern will continue.
I buy and hold stocks because I feel the company is in a good business and the price of the stock is cheap relative to what you are buying. As such, if the price of the stock falls (without a change to the fundamentals of the company) I want to buy more (assuming I have the money) not sell.
Therefore, I am not a fan of stop loss orders.
Here’s an example from my own lived experience:
A couple of years ago, I purchased a number of shares of Tesla at about $300/share with the underlying investing thesis that the world was turning a corner with electric vehicles. I then watched it drop from $300/share to $160/share until it slowly climbed its way up to over $2000/share. Yeah, the drop was a huge gut-punch and maybe at the time I was really questioning my decisions but the fundamental thesis held true and I am sure glad I stuck to it. A stop loss would have neutered the fun ride I enjoyed going all the way back up and then some.
So the moral is that a stop-loss might help you in some instances and can provide a tactical tool in your overall investing strategy, but it shouldn’t be the only tool. You don’t know what the future holds. For all you know, your sell point is $0.01 above the bottom right before it blows up.
Why on earth would I set stop loss orders?
Right now, I have shares of SPY which are currently worth about $370 each. What would I do if the price went down? Well...
- If the price went down to $350, I'd rather have the stock than cash, so I wouldn't sell.
- If the price went down to $300, I'd rather have the stock than cash, so I wouldn't sell.
- If the price went down to $100, I'd rather have the stock than cash, so I wouldn't sell.
- If the price went down to $10, I'd rather have the stock than cash, so I wouldn't sell.
- If the price went down to $1, I'd rather have the stock than cash, so I wouldn't sell.
The problem with selling after a loss is that, although it prevents you from losing more money, it prevents you from gaining more money, too! And in the stock market, gains happen more commonly than losses, which means that if I sell my stock, then the gains that I'm missing out on are greater than the losses I'm avoiding. That's bad.
That's why, so far, I've never put in a stop loss order.