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Understanding Stop Loss Orders

How Stop Loss Orders can Protect You

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When the bottom falls out of your favorite stock’s price a stop loss order on file with your broker can help ease the pain.

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 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 was when Merck, the pharmaceutical giant, pulled its blockbuster arthritis drug Vioxx off the market. Studies linked usage of the popular drug to an increased likelihood of heart attacks and stroke.

As soon as Merck made the announcement, its stock began dropping like a rock because investors knew how much the company was counting on profits from the drug.

Wiped Out

By the end of the day, the stock was down almost 27% or over $11 – wiping out billions in value of the company.

The stock opened around $45 the day of the announcement. If you had a stop loss order in for $40, it would have triggered very soon after the announcement.

When the market hit your $40 price, your stop loss order became a market order, meaning your broker sold the stock at the best current price. That may not have been $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.

You can also use stop loss orders to lock in profits, but

Important Points

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.

Conclusion

Stop loss orders are great insurance policies that cost you nothing and can save a fortune. Unless you plan to hold a stock forever, you should consider using them to protect yourself.

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