Managing Investment Risk with Stop Orders

By Brian Dolan

Why Learn to Manage Investment Risk?

Any investor who’s been in the markets for any length of time can tell you they don’t always go straight up. Market ups and downs are just part of investing. In some cases, market setbacks can even be viewed as a good thing:  opportunities to add to existing investments or enter new ones at lower costs.

Still, no one likes to see their hard-earned investing dollars decline in value. The key is to differentiate between the normal swings of asset prices and larger declines that could more seriously hurt your portfolio.  That boils down to ‘risk management.’

Risk management is all about investors deciding how much they are prepared to risk on any particular investment. No investor is right all the time, but successful long-term investors establish a disciplined risk management strategy and, most importantly, they stick to it. ‘Stop’ orders are an essential tool to help manage investing risk and minimize potential declines.

A ‘stop’ order is an order placed with a brokerage that will close out an investor’s open investment position, either completely or partially, in a particular security. If the investor’s position is long the security, meaning they own an individual stock or ETF, the stop order would be to sell all or some of the security.  If the investor is short the security, meaning they have previously sold the security, the stop order would be to buy the security and exit or reduce the short position. (Please note, DriveWealth does not currently offer the ability to sell securities short.) As just indicated, investors can choose to specify whether the entire position is closed or only a portion, potentially staggering stop orders in increments of the whole position in line with their investment strategy. (Please see important risk disclaimers below.)

Stop orders (stops) are frequently referred to as ‘stop loss’ orders, since they’re often used to minimize potential investing losses. If an investor owns a security (long position), they would be concerned about potential price declines and might place a stop order to sell if the investment declines below a certain price or loses a certain percentage or dollar value. If an investor has sold short a particular security (selling without previously owning it), they would be concerned about potential price increases, and they might place a stop order to buy if the security increases beyond a specific price or registers a loss over a certain amount.

It’s important to understand your brokerage’s stop order execution policies as they may differ from broker to broker.  In general, a stop order is ‘triggered’ once the market trades at the specified stop price. The order then becomes a ‘market order’ and is filled at the next available price, which may not be the price specified by the investor. For instance, a stop order to sell a security at $10.00 may be executed at $9.98 (or lower, depending on market conditions).

Stop orders are highly recommended to limit extreme losses on open investment positions.  Investors can use stop orders to reduce losses on open positions if markets move against them. For example, if an investor buys ABC stock at $100, she might decide that she’s only willing to accept a decline of 10% on the investment, so she could place a stop order to sell if the price falls to $90 per share.

Stops can also be used to protect gains or to take profit after a favorable price move. If the same investor above owns ABC stock she bought at $100, and the price increases to $110, she could raise her stop to $100, minimizing potential losses, or raise the stop to $105, to potentially lock in a portion of ABC’s increase.

Types of Stop Orders

  1. Financial stops:

    A financial stop is based on the monetary amount an investor is prepared to risk. For instance, an investor who owns $500 of a $100/share stock (5 shares) may only be willing to risk $50 on the investment ($50=financial stop).  That would translate to a stop order price of $90/share ($50/5 shares=10 price decline=$90/share price).  If the same investor owns $1,000 worth of the same $100/share stock (10 shares) and is still only prepared to risk $50, that would translate to a stop order price of $95/share ($50/10 shares=$5 price decline=$95/share). As can be seen, financial stops are heavily influenced by the size of the investment as opposed to market price changes. Financial stops can also be placed using percentage terms, where an investor might decide they’re willing to risk 15% on a particular investment.   If they own $1000 worth of a $100/share stock (10 shares), the 15% risk they’re willing to accept results in a potential decline of $150, meaning the stop would be placed at $85/share.

  2. Price or Technical stops:

    A price/technical stop is a stop order based on a specific price of a security, and not based on the monetary risk involved. Price stops are frequently based on technical analysis or significant historical price levels.  For instance, an investor could decide to stay invested in a particular security while it remains above the 100-day moving average, or the low for the year. The stop order would then be placed at the price indicated by those historical price points, and the monetary risk would then be determined by that price point.  For example, imagine a trend line or the 100-day moving average is located at $92.45 when a security is trading at $100 and the investor owns 6 shares.  If the stop is executed at $92.45, the investment would have decreased by $45.30 ($100-$92.45=$7.55 price decline * 6 shares=$45.30).

What's Right For You

Deciding which approach to use when setting a stop order depends on an investor’s overall strategy and experience. A relatively conservative, long-term investor might be inclined to focus on using financial stops, as they may provide a clearer understanding of the monetary risk involved with their portfolio strategy.  A more aggressive or experienced investor, especially one who employs a technical analysis approach, may focus on technical/price stops and adjust their investment size accordingly to manage their financial risk. Whichever approach, investors would be well-advised to consider using stop orders as part of their risk management strategy.

Important Stop Order Disclaimers:  Stop Order execution is usually certain, but price is not. In most cases, your order will be executed at a price that is close to the market price at the time the sell stop order is triggered. However, as an example, if a stock’s trading is halted and the stock price gaps down upon reopen (lower than the price at the time trading was halted), your execution price could be significantly lower than your sell stop price.

***Note: The entry of Stop Orders is available 24/7. However, Stop Orders will only be executed during the normal NYSE market hours (9:30 AM to 4:00PM Eastern Time Monday thru Friday). There is no guarantee that if a stop order is triggered, the investor will pay or receive the stop price.

Important risk disclaimer:  All investing carries risk. Past performance is not indicative of future returns, which may vary.  Investments in stocks and ETFs may decline in value, potentially leading to a loss of principal. Online trading has inherent risk due to system response and access times that may be affected by various factors, including but not limited to market conditions and system performance. An investor should understand such facts before trading.