Most of the time, checking the stock market is a waste of time for long-term investors. They are concerned with holding a great stock for a long period while it makes money for the investor.
However, there are a few times when it is important to watch a stock's price. For example, if you have a substantial profit and you don't want a severe dip to wipe out your gains.
But watching a stock on a daily (or more frequent) basis is not practical or possible – you are away from access to the market or you don't want to be bothered (while on vacation, for example).
You can use a stop-loss order to put a floor under the stock's price and prevent big losses.
A stop-loss order instructs your broker to sell when the price hits a certain point. The purpose of the stop-loss is obvious – you want to get out of the stock before it falls any farther.
A stop-loss order works like this: You tell your broker (enter a command in an online system) you want a stop-loss order at a certain price on the stock. When, and if, the stock hits that price, your stop-loss order becomes a market order, which means your broker sells the stock at the best market price available immediately.
Setting a Stop-loss
If the stock is trading at $30 per share and normally doesn’t fluctuate more than $1-$2, then a stop-loss order at $26.50 might be reasonable.
A good example of how investors could use the stop-loss order is when a company has some very bad news to share with the market.
As soon as the announcement is made, the stock may begin dropping like a rock because investors knew how much the company will be affected by the announcement. The announcement could be a devastating product failure or a collapsed merger or acquisition.
The news could also come from some dramatic change in the company's primary market or a new regulatory ruling that changes how the company makes money.
By the end of the day, the stock could be down significantly – wiping out billions in value of the company.
For example, say the stock opens around $45 the day of the announcement. If you had a stop-loss order in for $40 and the price plunged as other investors scrambled to get out of the stock, it would activate very soon after the announcement.
When the market hits your $40 price, your stop-loss order becomes a market order, meaning your broker sells the stock at the best current price. That may not be $40.
A fast-moving market may go past your target before your broker can fill your order. The good news is you probably want out of a plunging stock at the best price you can get and will take what you can get.
Here are some important points to remember:
- Be careful where you set your stop-loss points. If a stock normally fluctuates 3-5 points, you don’t want to set your stop-loss too close to that range or it will sell the stock on a normal downswing.
- Stop-loss orders take the emotion out of a sell decision by setting a floor on the downside.
- If you plan to be out of touch from the market, on vacation for instance, put stop-loss orders in so you have some protection against an unexpected disaster.
Stop-loss orders don’t guarantee against losses. When disaster strikes a stock, it may fall so fast the best you can hope for is to come out close to you price.
Stop-loss orders are great insurance policies that cost you virtually nothing (your broker may charge a small fee) and can save a fortune. Unless you plan to hold a stock forever, you should consider using them to protect yourself and even if you plan to hold the stock, things change.