Stop the losses (or - keep the profits!)

The stock market has recovered from the Sep 2008 - Mar 2009 brutal bear market.  General consensus is that 2011 will bring positive returns for 'long' traders.  As always, if you invest in individual stocks, some will do well and others...may drive you to drink. :(

So how do you prevent a loss from getting out of control? OR - even better - how can you lock in some of your gains?

You have a choice of three strategies:

1. Continuously watch your stock and sell when it gets too low.  Well most of us don't quite have the time to do that. Also, if the market gets volatile, even your best efforts may cost you a few percent.
2. Use options.  That's a good strategy if you are comfortable trading options.  I'll revisit this some other time.
3. Stop orders.  Simple strategy and very easy to implement.

A 'stop order' is a trade request, placed by you, saying "please execute a sell order if the stock gets to this price (assuming you are long on the stock).

There are two main variants of a stop order.  The difference is important.

1. Stop order.  This means that you are placing a market order when the stock reaches the stop price.
2. Stop limit order.  This means you are placing a limit order when the stock reaches the stop price.

Let's say you bought 100 shares of XYZ  at 55 a share.  If you place a 100 share stop order at 50 and the stock hits 50, your order will be executed as soon as possible at the current market price.  That means your order may be executed at 50, or 49.95, or 50.02 - you get the idea. If you place a stop limit order and the stock hits 50, your order will only be executed at 50 (or above). 

Put simply, the stop order guarantees execution, the stop limit order guarantees price.  Either action is sometimes referred to as 'getting stopped out of a position.'

We are approaching "Earnings Season", which means companies will be announcing CY Q4 earnings.  If you are long a stock that either has disappointing earnings or disappointing guidance, that stock may "gap" down 5%, 10%, or more at the open of the next trading day.  Yikes!  Be aware that in this situation, if you have a stop order and the stock gaps below your stop order price, you will get stopped out at market open, but at a price lower than your stop price.  If you have a stop limit order and the stock gaps below your stop limit order price, you won't get stopped out, and you will have to reissue your stop limit order (or just sell at market).

The only 'drawback' to having a stop order is you run the risk of getting stopped out of a stock that you think
has long term potential.  If that's the case, always remember two things about investing:

1. If you like an equity and you got stopped out of it, you can always invest in it again in the future.  Just make sure to consult your friendly tax accountant for the tax impacts of what you are doing.
2. Noone ever went bankrupt locking in profits.

You can use stop orders on any equity, including ETFs; however your broker may have restrictions on using stop orders on so-called 'penny stocks.'  You cannot use stop orders on mutual funds since they settle at day's end. You can use stop orders on any amount of shares you own for a given equity.  Stop orders are executed only during normal US market hours (9:30a to 4p ET). Check with your broker if your stop order is "good until canceled" or if it expires within a certain time period if not executed. You can always cancel your stop order and open a new one at a different price.

How you choose to use stop orders is based on your investment goals and how volatile the equity is.  There is no simple 'rule of thumb' on how to use stop orders.  Correction.  The 'rule of thumb' of stop orders is: use them!

Speaking of Investing...

MarketWatch has an interesting trading game that permits you to trade in companies that are announcing earnings for that week.  You have to enter your 'trades' before US market open on Monday.  You can go long or short.  You can invest in as many or as few of the eligible companies as you wish.  Your position gets closed out at US market close on Friday.  You then have new stocks to pick from for the following week.

I played this game in Q4 and had some fun.  Didn't come close to winning any week, but was profitable 3 of the 4 weeks. If you really want to win a week, you need to go "all-in" on one stock, either long or short, and hope your choice is correct.  Correction:  They now make you pick three (3) stocks,  and any one of them cannot exceed 80% of your portfolio. Anyway, go here Fantasy Earnings Trader , have some fun, and learn if trading equities of companies when they announce earnings makes sense for your 'real' portfolio.  The game starts Monday Jan 10, 2011.


The contents in this blog are my own and in no way represent official positions of any current, past, or future employers. I am not responsible for the accuracy nor the contents of links to any external sites. Financial topics are presented for educational purposes only and never represent a recommendation for an investment or strategy. Always consult with an investment adviser prior to making any investments. Past performance is never indicative of future results.