The Basics of Stop Orders and other conditional orders

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Managing your emotions when it comes to personal finance

I recently commented that by covering all four “personal finance” bases and having a plan of action, many would significantly lessen the emotional roller coaster when dealing with their money. If you think about it, there is not much you can get emotional about if you already have a clear, coherent and consistent plan for building your wealth. Today, we will target the emotional roller coaster when it comes to investing, more specifically the use of Stop Orders for our investments.

What is a Stop Order?

Stop orders are known as conditional orders because a condition is created. For instance, if it looks like it’s going to rain outside, I will bring my umbrella along. But if it doesn’t rain, I won’t use my umbrella. We have created a condition of using my umbrella only if it rains. But this time, we create a condition for our investments.

How do I use a Stop Order?

For instance, if our stock is currently trading at $50 and we don’t want to lose more than 10%, we place a Stop Order to sell at $45, which is 10% away from $50.

$50×10%=$5 Þ $50-$5=$45

Should my stock trade down to $45, our Stop Order will trigger to a market order, and we will be filled at the next market price. If we place a fixed price for our stop order at $43 instead of using a percentage, our stock won’t get executed to sell until the price hits $43 or less. Whether you choose a fixed price or a percentage price, a Stop Order will allow us to get out at a certain percentage (5%, 10% or more) or fixed price ($46, $44, $42), and thereby taking the emotion out of knowing when to sell.

But be careful, you can’t set it and then forget it. Stop Orders can have an expiration date that will vary depending on the type of Stop used (see below) and the policies of the broker you are with (120 days with my broker). This is why you should take some time to monitor your investments every week or so. You many also want to consider moving your Stop Order up as your investment moves up so you can lock in profits.

But why use a Stop Order?

Stop Orders will help us control our emotions by taking the decision of when to sell out of our hands so we don’t have to guess when to get rid of losing investments. Many often don’t want to sell or don’t know when to sell losing positions simply because we don’t want loses ever. So we often refuse to take losses, and our investments go lower and lower and lower…

Taking losses is part of the game, and it happens to everyone, including the best. But the difference between the professionals and others is that the professionals have a definite plan to get out. There are no fancy tricks or secret rooms, just a decision beforehand to say this is all we are going to risk. Otherwise, we will not have the capital left to make money on the next trade. Preservation of our capital is the key to growing wealth, and Stop Orders help us to preserve our money.

How much of a Stop should we use? Considerations…

That depends on how much you are willing to lose. Would you be comfortable losing 5%, 10%, 20%? If you said, “I don’t want to lose a penny,” then you are definitely a candidate for always using stops. Here is one way to think about it. If you get out at a 5% loss, and it goes down another 10%, did you do the right thing? Absolutely! Will it come back? Who knows, maybe never? This is why you have a Stop Order in the first place: to stop yourself. Here are some other considerations:

What are you trading: It also depends on what you trade. For example, the stock market typically doesn’t move more than 20% in a given year, so using a Stop Order for an Exchange Traded Fund (ETF), which mirror indexes like the Stock Market, tend to be tighter than individual stocks.

Volume and Price: There are also other considerations like volume and price. A lighter volume stock which trades less than 250,000 shares in a day may make wider moves than a stock that has more people actively trading it. More participants generally mean better valuation of the true price of the stock. The price of a stock is also a concern as a $100 stock may move a lot quicker in volatile markets then a $10 stock.

News and Volatility: If the stock has been in the news recently, the price may become more volatile and move around more than it had in the past. Or, if earnings are expected to come out, the stock may become more volatile (not recommended to trade). In addition to stock movements, volatility of the general markets can also affect where to place stops, especially when you trade mostly ETFs.

Timing is also a key issue in determining a Stop. Placing a Stop Order after a big run up or before key earnings will more likely trigger your Stop. There are strategies, like Technical Analysis, to help you time into positions. Think about it. Today is not the only day to buy into your investment. Just like shopping, you buy when there is a sale.

As you can see, there are many considerations to determining a good point to place your Stop Order, and probably even more that I haven’t considered in this post. In the end, it’s important to choose a Stop program that best suits you.

When should we place a Stop Order?

We should place a Stop Order within 15 minutes of placing your buy order. The longer you wait, the less likely you are to place a Stop Order. Therefore, you should make it automatic. Place the order to buy, and then place the Stop Order – a 1-2 punch!

Implement the 2:1 rule

I personally like to use 7% Stop Order on stocks and less on ETFs (market indexes). How come? Let’s say I invest in 3 stocks, each at $100. I can lose 7% on 2 of these $100 stocks ($7 on each or $14 total) and only have to make $14 on 3^rd $100 stock to break even. I can lose twice at 7%, make 14% on the 3^rd stock, and still break even. Again, you can choose whatever percentage you want, but I would stick with a percentage that makes sense if you lose twice and win of the third, you can still realistically break even.

Are there other types of Stops I could use?

There are Stop Limits, which limits the least you want to sell your position at once your order is triggered (not recommended, unless you are using Stop Limits to buy into a position).
There are Trailing Stops, which will follow or “trail” the price of the stock by a certain amount (say $3) and only triggers once the stock retraces $3 from the highest point after you entered(recommended for profit protection)
There are Contingent orders, where your order sits with your broker instead of as a live order in the markets for the world to see and possibly execute.

The World of Trial and Error

In the beginning, you may experience a great deal of trial and error. Unfortunately, there is no magic percentage where to place your stop or at what point it should be placed. We just don’t know where the markets or individual stocks are going to go in the future. But by using a Stop program that works for you, you can at least become better at handling loses and preserving your wealth for tomorrow’s winners.

In my guide to investing, I not only cover all the types of Stop Orders you need to know and what you should know about them, I also discuss timing into positions and staying out of more volatile markets, which occur most often with bear markets. The most important aspect you need to know is to have the proper tools in place so investing in the markets can become a pathway to wealth!

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