A protective stop is a strategy where a stop-loss order, stop-limit order or similar is utilized to protect existing gains or limit further losses. It prevents you from losing more money then you can afford to lose.
- You purchase 100 shares for $20 per share. Afterward, you make two orders regarding this position.- If the share price goes up to $25, all 100 shares should be put up for sale. You want to realize this profit rather than hang on to the position hoping for an even bigger gain. If the share prices go down to $10, all 100 shares should be put up for sale. You want to realize the loss rather than risk losing even more.
Automatic sell orders of this type can never guarantee that a sale will take place. You offering the shares for sale isn’t enough to make a trade, there must also be someone there willing to buy. If the market is reasonably liquid, you can expect your automated orders to quickly result in a trade, since a liquid market is characterized by many bids and ask offers and small spreads. In a market that isn’t very liquid, it can be difficult to execute a trade quickly, and automated sell orders become less efficient.
Although I generally advise people to use stop-loss orders to manage risk, I also want to highlight the fact that there are situations where a stop-loss can cause problems.
- You buy shares for $50 per share.
- You put in a stop-loss order to automatically offer the shares for sale if the market price drops down to $40 and keep offering them for sale until a trade has been done. This type of stop-loss order is also known as a stop-market order.
- The company is doing great and the share price is soaring.
- When the share price is at $60, sudden political turmoil causes a sharp downturn in the stock market. The share price quickly drops down to $35 before rebounding to $55 again.
- You come home from work, log into your stock trading account and see that all your shares were sold for $39,99 because of the automated stop-market order.
Without a stop-market order in place, you would still be the owner of those shares and no loss would have been realized.
A stop-limit order is an alternative to the stop-market order. Stop-limit orders seek to sell the asset at a specified limit price once a specified price level is breached, rather than seeking to sell the asset at any market price once a specified price level is breached.
Unlike a stop-market order, the stop-limit order imposes a limit on the price range within which it can be executed. While a stop-market order only consists of one price point (where to trigger the sale order), a stop-limit order consists of two price points: where to trigger the sale order and the minimum accepted sale price.
Example: You buy shares for $50 each. You put in a stop-limit order with the following parameters:
- The shares should automatically be offered for sale if the market price drops down to $40.
- The shares cannot be sold for less than $30.
This means that if no one is willing to purchase your shares for $30 or more, no trade will take place, regardless of how far down the market price drops.
So, in essence, with this stop-limit order, you have decided that if you can’t get at least $30 for your shares you rather hang on to them, take your chances and see what happens. Of course, if the company ends up filing for bankruptcy you would have been better off selling your shares for $20 a piece rather than hanging on to them. On the other hand, if it is only a temporary downturn and the share price eventually rebounds, you will be happy that you didn’t sell them for $20 and realized a $30 loss per share.
N.B! Even if you have set the lower limit for your stop-limit order at $30 you can always manually offer your shares for sale with a lower ask price than $30. The stop-limit order is an order for an automatically executed trade.
Day order or Good-Until-Canceled?
A good-until-canceled order will be in place until you manually cancel the order. An alternative is the day order, which his only active during a specific trading day and automatically removed as that trading day ends.
In the context of stop-limit orders, it is important to check if your stop-limit order is of the type that will remain in place until canceled because that can lead to undesired consequences.
Same parameters as in the example above. You buy for $50 per share, in but in a stop-limit order with the price levels $40 (shares automatically offered for sale) and $30 (do not sell below this price).
The share price drops to $40 and your shares are automatically offered for sale. No one is willing to buy for $30 or more and no trade takes place. The market price drops down to $20 before it starts crawling up again. You are happily watching the market price going up, grateful that you didn’t panic and manually sell your shares during this dramatic but short-lived price drop. However, as soon as the market price reaches $30, your shares are automatically offered for sale and someone purchases them for $30. That’s because your stop-limit order was still in place. You have now realized a $20 loss per share. You angrily watch the market price climb even higher, wishing you had remembered to remove the stop-limit order.
This is a stop-order that can be set at a defined percentage away from an assets current market price or at a defined dollar amount away from an assets current market price. The idea is to automatically offer the asset for sale if the market price makes a substantial move in the wrong direction, rather than automatically offer the asset for sale once the market price reaches a certain predetermined price.
Example #1: You buy shares for $50 each. You think about putting in a stop-market order that would automatically offer the shares for sale if the market price drops down to $40. Ultimately, you decide to go with a trailing-stop order instead. You employ a trailing-stop order that will automatically offer the shares for sale if the market price drops more than 15% from whatever the market price is when the drop starts.
Over the next few weeks, the share price is rising. Eventually, it is at $100. Then, it starts going down. A drop from $100 to $85 is a 15% drop, so if the stock price goes below this your trailing-stop will activate and offer the shares for sale.
Example #2: You buy shares for $50 each. You employ a trailing-stop order that will automatically offer the shares for sale if the market price drops by more than $10 from whatever the market price is when the drop starts. Over the next few weeks, the share price is rising. Eventually, it is at $100. Then, it starts going down. When the price drops below $90, your trailing-stop will activate and offer the shares for sale.
If you use an ordinary fixed-price stop-market order instead of a trailing-stop order, you need to continuously update the order as the market price increases to get the same result.
A trailing-stop order can be set with or without a limit.
Limit example: Automatically offer the shares for sale if the market price drops by more than 10% but do not execute any sale for less than $55 per share.
No-limit example: Automatically offer the shares for sale if the market price drops by more than 10% and accept any bid, regardless of how low.