When I talk about investing with people, it’s natural that most of them don’t understand there are a lot of different types of orders. Most people know that you can place an order to buy or sell when a stock hits a certain price, but it gets more sophisticated than that. One form of sophistication is the trailing stop-loss order, which is available from any fully equipped discount brokerage.
It works like this. Suppose your shares of Baloney, Inc. (BLNY) are way up. You’re not eager to sell, but you think the markets are high, and you really don’t want to ride BLNY down the chute of a big selloff. Okay. You place a trailing stop-loss order to sell all shares, good till canceled (at Fidelity they expire after a max of six months). The trigger condition is a percentage that you choose. If you pick 1%, you must really want out, because a 1% drop in value is typical on a down market day–and isn’t even remarkable over two days or more. If you pick 5%, it would take a very big single day of loss to trigger that, or a loss of that size spread over multiple days.
The mechanics of this are a headache for the brokerage, but that’s why they get paid. Suppose BLNY is at 100 when you place a trailing stop-loss order to sell it, trigger 5%. As of right then, the trigger price is 95. However, if BLNY goes over 100, the trigger point is recalculated (each time it gets above the high) based upon a 5% drop from the new price. So if BLNY climbs to 120, without ever declining 5% from its highest price since the order, its trigger point will be 114. That is 5% less than 120. The brokerage keeps this stuff in a separate file so it can keep updating your trigger point. When it sells, we say that it ‘stopped out.’
Seems like cheating, doesn’t it? That’s what seasoned investors do any way they can legally or practically do: cheat. Of course, you have to realize what exactly occurs with this type of order. When your shares drop to the trigger point, your order converts to a market order (and it is not going back; the die is cast). You may not get your trigger price, though it should be close. There has to be someone wanting to buy the shares for that market price. A market order, the simplest form of order, simply says ‘sell this now at what the market will pay.’ No type of order can create liquidity (investor-speak for ‘someone wants this, so I can sell it’) if liquidity doesn’t exist.
Can this hurt you? Well, there is no crying in investing. Big kid tools are for big kid investors. Most people are thinking of crash protection, but remember that once a trigger point is established for the order, it will never go down. If you aren’t serious about protecting some form of profit (or avoiding further faceplant), better not place one of these, because the smaller your % loss specified in the order, the more likely it is that a moderate market shift could trigger your sale.
My own belief on stop-loss orders is that they are for times when you think the market is stupidly high, you’ve profited handsomely from it, and you’re ready to protect the profits. I’m at that point right now. There isn’t really a good reason for the markets to be as high as they are, at least not as far as I can see; banks still aren’t lending much, interest rates on savings are an insult, there’s no big job boom, and the economy is still fought over by the macaques, gibbons, chimpanzees and ourangoutangs in Congress, who are doing nothing to help it, being too distracted by ideological feces-flinging competitions. If there’s a big long market slide, I expect to buy these stocks back at discount prices. It’s not that I don’t like the companies’ prospects; it’s just that in investing, I don’t give a damn about anything but money. I gain no emotional satisfaction from holding Berkshire Hathaway (BRK.B) shares; I just think they are a good investment. However, I’m not stopping out of those, because I think they are such a good investment they will weather a market decline very well. I’m not stopping out of my dividend farms (closed-end bond funds), because I didn’t buy them for capital appreciation. I bought them so they’d pay me money every month. They will still do that, by and large, regardless of what their prices do.
We–you and I–didn’t invent this game. We have the right to play it for keeps, for our own reasons, using whatever tools are available to us. For me, one of those is the stop-loss order.