The Stop Loss and Exit Price when Selling a Stock

Posted on May 17th, 2010 by Jim R

The Stop Loss, essential for risk management

The main topic of this post is to introduce the Stop Loss, which, as its name implies, involves establishing a price point that can limit the loss that will be suffered when a stock begins to fall in price below the price at which it was purchased.

But first some background
Most people, when learning how to trade in stocks after they have opened an account and are ready to begin actively trading, concentrate on what particular stock or stocks to buy, what the current trading prices of those stocks are, and what they are willing to bid for those stocks. Then they place the order and become a shareholder with the objective and expectation of watching the stock rise in price and make their stocks more valuable until there comes a day when, for whatever reason, they then sell those stocks, hopefully above the purchase price for a reasonable gain.

But there is something missing in that scenario, what if the stocks fall in price after the purchase, or even after first making a gain in price? It happens all the time. Sometimes a stock price reversal is small, of little consequence and the stock can continue to be held for the time when it will again increase in price. But sometimes the price drop is not small, and that is a frequent occurrence in both individual stocks and in the entire stock market.

Always have an Exit Strategy
When learning how to trade stocks, one of the principal lessons to be learned is to set an exit price, or a series of prices actually, even before the stock purchase transaction is completed. Which means knowing the target price at which the stock will be sold if it has achieved its full potential in the time considered appropriate or if it falls in price to below an acceptable level.

Depending on the basis on which a stock purchase was predicated, the trader should be able to estimate a target price that the stock can achieve based on what is then known about the specific stock and other related situations such as the overall performance of the stock’s sector and the general market, and perhaps, the chart pattern exhibited by the stock’s trading to date.

Obviously these conditions will change as time passes, sometimes for the better sometimes not, so the target price is subject to change but the trader can adapt and revise expectations to accommodate to whatever occurs. Keeping in mind that the holding period to reach the target should not be excessively long, a relative term but one that makes sense in the trading approach that is different from investing where the long term is usually the rule.

Set a “stop loss” price at the same time as making the stock purchase
A wise practice, essential for good risk management, is to set a selling price using a stop loss order, described below, entered with the instructions to the broker when the stock is purchased. If not then, do so soon after.

Not everyone agrees with the strategy of using a stop loss, suggesting it might be triggered in an unnatural fashion and the stock sold needlessly after which it soon bounces back. But not using a stop loss means that the action in the stocks must be watched closely with a clear and firm decision made immediately they fall to an exact lower price at which a sell order must be placed personally rather than automatically as in the case of the stop loss.

Requiring such an action involves not only a lot of effort in tracking the movements but also carries the risk of the very human tendency to procrastinate or waver undecidedly while the stock falls further, creating greater losses. On the other hand, the stop order is like an insurance policy, a form of protection.

The Stop Loss
Setting the stop loss price serves to minimize the downside risk in the event that the stock falls lower in price from its purchase price.

The stop loss also serves to protect a gain that may have occurred since the original purchase price but where the stock, after reaching a higher price, begins to fall back.

The amount of acceptable loss can be set in several ways, perhaps at a fixed dollar amount, or as a percentage of the purchase price. A commonly used amount is 8 percent, but note this is a target price that when reached becomes a commitment to sell “at the market”.

The actual sell price may be lower than the stop loss price
The Stop Loss is a predetermined order to sell a stock at some future time should the stock reach the given stop price and then it becomes executable as a market order immediately.

But note: as a market order, if and when the stock reaches that given price, it then causes the stock to be sold at the prevailing bid price which in reality may be lower than the price specified as the stop price, that might be a little or a lot different depending on the trading volatility of the issue.

The stop loss cannot guarantee the sell price, only that an order to sell will be triggered when the stock reaches the set price of the stop loss, but the best price possible at the time will be obtained once the stop loss is triggered.

I see little value in an alternative method where the stop price can be specified to sell at only at a specific price. This might seem plausible when setting to sell at a satisfactory higher target price but if that price is not quite reached and the stock falls back, the trader is left holding a stock that could have made a profit, and having not done so, may even fall to a much lower price.

Whatever the gain in price that a stock has achieved above the purchase price it is not a profit until it is sold. Don’t let profits just fade away, a stop loss can help protect profits before they do.

The Trailing Stop
A Trailing Stop is an excellent form of stop loss because it moves up and down in concert with the underlying stock’s movement, rising if the stock rallies and falling if the stop reverses but maintaining the same range of difference, whether it be by percentage or fixed dollar amount.

When learning how to trade stocks there is always lots more to cover, as I have mentioned elsewhere, than can be fully explained on this website or any other single source.

An important market information source for learning how to trade stocks:
A great daily reference that encompasses a wide range of stock market activity, news, stock lore, charts, stock ratings and research tools, in fact everything up to date and relevant is the IBD, the Investor’s Business Daily, available at many city newsstands for about $3 a day, Tuesday’s through Saturday, 5 days a week.

Next post coming in this How to Trade Stocks Guide:
A Look at Support and Resistance Levels.

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