Stock Stop Loss - Benefits and Pitfalls

By using some type of stock stop loss strategy, traders and investors are able to implement a mechanism into their strategies that will help to: 1) minimize potential losses, 2) avoid catastrophic losses and 3) lock in profits.

While no individual technique is going to work in all situations, not having any type of mechanism in place prior to entering new positions is typcially not the best choice of action, especially over the long run.

There are various types of stock stop loss techniques which can be tested, and should be tested, to see which method works in your own situation. What works for one person, may not necessarily work for another, although it may be a good place to start.

What is a Stock Stop Loss?

This is a specific rule, guideline or mechanism with certain criteria, put in place as part of a trading or investing strategy (ideally prior to entering a position), which when the criteria is met, causes an open position to be closed, either automatically or by manually entering a closing order.

Stock Stop Loss

Example of having a stock stop loss in place: Trader Larry enters into a new position by purchasing $10,000 worth of shares of GM during the first day of trading after their recent IPO, for $35.50 per share. Trader Larry realizes that stocks go up AND stocks go down, and that sometimes we make the wrong decisions.

Because of this, Trader Larry has a stop loss mechanism in place where he has $500 at risk per position in his portfolio at any given time. This means that if shares of GM move below $33.72, he exits his position. ($35.50 minus 5%)

The second day of trading comes along and shares of GM continue their decline from their opening day highs. Prices move lower and drop to $33.11 before 10:00 comes around. Trader Larry exits his position at $33.50 (prices were dropping so fast, this was the earliest he could get out as anyone with any sense realized they had made a bad decision).

A year goes by, shares of GM are trading at $17.75 a share and Trader Larry looks back and says: "boy am I glad I had a stock stop loss in place with my position in GM that I had". (Trader Larry lives happily ever after.)

Example of not having a stock stop loss in place: Trader Lori enters a new position by purchasing $10,000 worth of shares of GM on the opening day of trading after their latest IPO, for $35.50 per share. Lori loves GM and feels she got a good buy.

As the first day of trading goes by, prices in GM shares lose momentum, steadily. Lori still has a good feeling about her decision though. After a few weeks go by, shares of GM are now trading at $28.00 per share and Lori is still holding her shares.

1 year later, GM is trading at $17.75 per share. Lori's original $10,000 investment is now worth a mere $5,000. Next, GM announces another stock offering, diluting the value of Lori's shares even further, but Lori still has a good feeling about GM.

Eventually, when shares of GM reach sub-$10.00 price levels again, Trader Lori says to herself: "Damn it! I wish I had some sort of stock stop loss in place! One of these days I'm going to learn not to try and get ahead by cutting corners...". (Lori is now miserable and decides to start buying hot flying Penny Stocks to make up for her losses in GM).

So the next time you enter into a new position, whether it be for a short term trade or a long term investment, think about having some sort of rule, guideline or mechanism in place, and follow it, so you won't end up feeling like Trader Lori.

I have several more articles to learn more about different stop loss strategies that can be implemented along with examples on the following pages:

Return From "Stock Stop Loss" To "Stock Trading Risk Management"

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