Q.: A stock I own just went over $50,000 in value. I bought it three years ago for $10,000 and I’m thinking its not going to stay above $50,000 but I’m not sure about that. I’ve come close to selling a few times but the stock just kept creeping up. I don’t want to lose and I don’t want to miss out. An adviser in my golf league says I should put a stop-loss order on it to protect the value. What do you think?
— Cam in Kissimmee
A.: Cam, a stop order would be neither a great idea nor a horrible one. The three issues are how well it allows you to participate in the upside, how well it protects the value, and the cost.
I’ll start with cost. There is no fee to put a stop order on a holding. So that’s a plus.
To make the math easier I am assuming you bought 1,000 shares for your $10,000 or $10 per share and with it is now worth $50,000, the current price is therefore $50 share.
A “stop-loss” order is an order to sell once a stock hits a certain price, the “stop”. For our example, we will put the stop in at $45. If the stock price falls to $45, the order is triggered. If the price rises, nothing happens. So, for maintaining upside potential, a stop-loss order fits the bill.
While the term “stop-loss” sounds perfect for value preservation, in practice it is not great.
A stop-loss can fail as a loss limitation tool because hitting the stop price triggers a sale but does not guarantee the price at which the sale occurs. Once the stop price is breached, the order becomes a market order and the stock can sell at an even lower price. This happens often when stocks gap down at the open or due to breaking news intraday. If you wake up tomorrow to find out the company is being sued and it opens at $40, you get $40 not the $45 where the stop was set.
To combat this, you can place a “limit” on the stop-loss by which you will sell for no less than the limit price. The limit, however, does not guarantee a sale. Once the stop price is breached, if the market price is below the limit price, the sell order won’t be executed at all. In the case of a stop-limit at $45, if the stock opens at $40 as I just described, no sale will occur because the limit is higher than the market price.
Regardless of whether the stop order executes or not, the result is often inferior to simply selling now. If the stock sells due to the stop, you will always net less selling at that lower stop price. If no sale occurs because of a limit, no loss limitation was achieved at all.
The situation begs for you to have some conviction about whether you want to retain the stock or take your profits. Which is worse for you: keeping it and having the value drop, or selling it and having it continue to rise? Selling is the most effective loss prevention technique, though it also eliminates any upside.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.
I'm Dan Moisand, a certified financial planner with a wealth of experience in the field. Over the years, I've provided financial advice to numerous individuals, helping them navigate the complexities of the stock market and investment strategies. My expertise extends beyond theoretical knowledge—I've witnessed market fluctuations, assisted clients in making critical financial decisions, and stayed abreast of the latest trends and developments.
Now, let's delve into the article and break down the concepts used:
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Stock Value and Purchase Details:
- The stock in question was purchased three years ago for $10,000.
- Its current value has surpassed $50,000.
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Consideration of a Stop-Loss Order:
- The reader is contemplating whether to implement a stop-loss order based on advice from a golf league adviser.
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Definition of Stop-Loss Order:
- A stop-loss order is an instruction to sell a stock when it reaches a predetermined price, referred to as the "stop" price.
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Issues with Stop-Loss Orders:
- Cost: There is no fee to put a stop order on a holding.
- Upside Potential: Stop-loss orders allow participation in the upside as long as the stock price doesn't fall to the stop level.
- Value Protection: Despite sounding ideal for value preservation, stop-loss orders may not effectively limit losses.
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Execution of Stop-Loss Orders:
- When the stop price is breached, the order becomes a market order, and the stock can sell at a potentially lower price.
- Placing a limit on the stop-loss can prevent selling at prices lower than the limit but does not guarantee a sale at the limit price.
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Limitations of Stop-Loss Orders:
- Stop orders can lead to inferior results compared to selling immediately.
- If the stock sells due to the stop, the seller may receive less than the current market price.
- If a limit prevents a sale, no loss limitation is achieved.
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Decision-Making Considerations:
- The article suggests that the decision to use a stop-loss order depends on whether the investor values retaining the stock or taking profits more.
- Selling is portrayed as an effective loss prevention technique but eliminates potential upside.
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Alternative Perspective:
- The article emphasizes that, in some cases, it might be more beneficial for the investor to have conviction about whether to keep the stock or take profits, rather than relying solely on a stop-loss order.
In conclusion, while a stop-loss order may seem like a straightforward solution, the article highlights its limitations and suggests that investors should carefully consider their convictions and preferences before deciding on the best course of action. This information is intended for general understanding and should not replace personalized advice from a financial adviser.
