How to use stop losses to pro­tect your port­fo­lio

We ex­plain a sim­ple way to avoid los­ing lots of money on the mar­ket

Shares - - CONTENTS -

In­vestors can min­imise their losses on the mar­ket when things go bad by set­ting up a stop loss or­der. It is a trig­ger to sell an in­vest­ment should the price fall be­low a cer­tain level.

For many peo­ple -20% is deemed the ap­pro­pri­ate level. We would ap­ply a -30% stop loss for more illiq­uid stocks.

It is a form of pro­tec­tion but not a guar­an­tee that you will never lose money. There are also down­sides in that you might exit an in­vest­ment only for it to sud­denly re­cover in value and thus you lose out.

The ben­e­fits of cap­ping un­fore­seen share trad­ing losses are fairly ob­vi­ous, if they work as planned.

Im­ple­ment­ing a stop loss may also help an in­vestor feel more at ease with the in­her­ent risk of buy­ing and sell­ing shares, in­vest­ment trusts or ex­change-traded funds.

It sug­gests some­one doesn’t have to mon­i­tor daily move­ments in their in­vest­ments. That might mean get­ting a bet­ter night’s sleep.

In this ar­ti­cle we dis­cuss the pros and cons of us­ing stop losses and the other ways in which you can help avoid in­cur­ring a large dent in the value of your port­fo­lio or los­ing pre­vi­ously-made gains.

WHAT IS A STOP LOSS?

A stop loss is an or­der placed with your stock bro­ker or on­line share deal­ing plat­form that will au­to­mat­i­cally trig­ger an or­der for a spec­i­fied in­vest­ment to be sold once it falls to spe­cific price or per­cent­age be­low a level set by your­self.

You typ­i­cally set up a stop loss after you’ve bought a share, in­vest­ment trust or ex­change­traded fund. Many ISA, Sipp (self-in­vested per­sonal pen­sion) and Deal­ing Ac­count providers will let you have a stop loss in place for a set pe­riod of time, typ­i­cally up to 90 cal­en­dar days.

Dur­ing this pe­riod you can amend or can­cel the stop loss, pro­vided it is not in the process of be­ing ex­e­cuted. There shouldn’t be a charge to place a stop loss but you will pay the nor­mal deal­ing fee when it is trig­gered and your in­vest­ment is sold.

Your plat­form provider will at­tempt to sell your in­vest­ment once the stop loss has been trig­gered, but there is no guar­an­tee that you will sell AT the stop loss price. This is ex­tremely

-20% is a typ­i­cal stop loss level

im­por­tant and some­thing that is mis­un­der­stood by many in­vestors.

As an ex­am­ple, let’s say you buy a stock at 150p and you would like to sell it if the price drops by 10% from the point of pur­chase.

You is­sue a stop loss or­der at 150p mi­nus 10%, or 135p. If the share price reaches 135p, the stop loss trig­gers a mar­ket or­der to sell the shares at the next avail­able price.

Most mid and large stocks are liq­uid enough to avoid de­lays in find­ing a buyer for your in­vest­ment. Most of the time, the trade should be in­stan­ta­neous. Smaller com­pa­nies can be more illiq­uid so you may en­counter pe­ri­ods when you can’t ex­e­cute a sell trade or your bro­ker ends up sell­ing the stock at a lower than de­sired price.

THE PER­ILS OF PROFIT WARN­INGS

The other is­sue to con­sider is that your stop loss might be set far higher than the price at which a com­pany starts trad­ing on a day when it is­sues very bad news.

For ex­am­ple, the com­pany in our pre­vi­ous ex­am­ple is­sues a profit warn­ing and its shares plunge 30% at the mar­ket open to 105p. Your stop loss was set at 135p.

The first op­por­tu­nity your bro­ker has to sell your shares is 105p; hence you will exit the trade at a lower than de­sired level.

IS THERE SUCH A THING AS A GUAR­AN­TEED STOP LOSS?

One so­lu­tion to this prob­lem is to use a ‘guar­an­teed stop loss’ which gets you out of the trade at the de­sired price.

This fa­cil­ity is only avail­able to peo­ple trad­ing the mar­kets via con­tracts for dif­fer­ence or spread bet­ting, which are very high risk ac­tiv­i­ties. To give you an ex­am­ple of the as­so­ci­ated costs, trad­ing plat­form provider IG says it charges 0.3% of the un­der­ly­ing trans­ac­tion value in or­der to have a guar­an­teed stop loss.

An­other is­sue may be a short-term mar­ket shake-out trig­ger­ing your stop loss, only for the shares to re­cov­ery in the sub­se­quent days and weeks. That locks in a loss that might have been rid­den out in time.

IT con­sul­tancy FDM (FDM) is a clas­sic ex­am­ple. In March 2016, we flagged the shares at 539.5p. In June 2016 the Brexit re­sult sparked a mas­sive sell-off in the share price, fall­ing to 432p.

Any­one who bought FDM at 539.5p and had a 10% stop loss would have had a sell or­der trig­gered at 485.55p and missed out on an im­pres­sive and rapid re­cov­ery. Yet half year re­sults in July bol­stered con­fi­dence and the re­cov­ery ac­cel­er­ated, the stock hit­ting 654p by early Au­gust. FDM has sub­se­quently risen fur­ther.

WHO SHOULD USE STOP LOSSES?

Chris Beauchamp, chief mar­ket an­a­lyst at IG, says any­one trad­ing the mar­ket on a short-term ba­sis should use stop losses. As for longer term in­vestors, their us­age is more open to de­bate.

You don’t want to get need­lessly pinged out of an oth­er­wise sound in­vest­ment sim­ply be­cause the mar­ket has run into a spell of volatil­ity.

In­vestors who like the idea of stop losses might look at a one-year share price chart to get an im­pres­sion of how volatile a stock might be and set a stop loss level ac­cord­ingly.

OTHER FORMS OF ‘PRO­TEC­TION’

A few in­vest­ment plat­forms of­fer trail­ing stop losses which pro­tect gains by en­abling a trade to re­main open and con­tinue to profit as long as the price is mov­ing up­wards. The trade closes out if the price falls by a spe­cific per­cent­age or more. More com­mon is the abil­ity to place a limit or­der. This is an or­der to sell – or buy – a share, in­vest­ment trust or ex­change-traded fund at a spec­i­fied price or bet­ter. In terms of sell­ing a share, it tends to be used as a way to lock in profit rather than min­imise loss.

For ex­am­ple, you might have bought a com­pany at 400p and the high­est price at which it has traded over the past 12 months is 500p. You might set the limit or­der to sell the stock at 505p in the hope that the shares will break that 12 month record in the near fu­ture. The limit or­der means you will sell at 505p or more.

The price at which you sell de­pends on the best pos­si­ble price ob­tained by your bro­ker once they’ve got the in­struc­tion to sell.

Please note that your bro­ker won’t guar­an­tee they ful­fil your limit or stop loss or­der; as it all de­pends on mar­ket fac­tors such as liq­uid­ity. (SF)

Limit or­ders can help you pro­tect profit

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