Investors can minimise their losses on the market when things go bad by setting up a stop loss order. It is a trigger to sell an investment should the price fall below a certain level.

For many people -20% is deemed the appropriate level. We would apply a -30% stop loss for more illiquid stocks.

It is a form of protection but not a guarantee that you will never lose money. There are also downsides in that you might exit an investment only for it to suddenly recover in value and thus you lose out.

The benefits of capping unforeseen share trading losses are fairly obvious, if they work as planned.

Implementing a stop loss may also help an investor feel more at ease with the inherent risk of buying and selling shares, investment trusts or exchange-traded funds.

It suggests someone doesn’t have to monitor daily movements in their investments. That might mean getting a better night’s sleep.

In this article we discuss the pros and cons of using stop losses and the other ways in which you can help avoid incurring a large dent in the value of your portfolio or losing previously-made gains.

What is a stop loss?

A stop loss is an order placed with your stock broker or online share dealing platform that will automatically trigger an order for a specified investment to be sold once it falls to specific price or percentage below a level set by yourself.

You typically set up a stop loss after you’ve bought a share, investment trust or exchange-traded fund. Many ISA, Sipp (self-invested personal pension) and Dealing Account providers will let you have a stop loss in place for a set period of time, typically up to 90 calendar days.

During this period you can amend or cancel the stop loss, provided it is not in the process of being executed.

There shouldn’t be a charge to place a stop loss but you will pay the normal dealing fee when it is triggered and your investment is sold.

Your platform provider will attempt to sell your investment once the stop loss has been triggered, but there is no guarantee that you will sell AT the stop loss price. This is extremely important and something that is misunderstood by many investors.

As an example, let’s say you buy a stock at 150p and you would like to sell it if the price drops by 10% from the point of purchase.

You issue a stop loss order at 150p minus 10%, or 135p. If the share price reaches 135p, the stop loss triggers a market order to sell the shares at the next available price.

Most mid and large stocks are liquid enough to avoid delays in finding a buyer for your investment. Most of the time, the trade should be instantaneous. Smaller companies can be more illiquid so you may encounter periods when you can’t execute a sell trade or your broker ends up selling the stock at a lower than desired price.

The perils of profit warnings

The other issue to consider is that your stop loss might be set far higher than the price at which a company starts trading on a day when it issues very bad news.

For example, the company in our previous example issues a profit warning and its shares plunge 30% at the market open to 105p. Your stop loss was set at 135p.

The first opportunity your broker has to sell your shares is 105p; hence you will exit the trade at a lower than desired level.

Is there such a thing as a guaranteed stop loss?

One solution to this problem is to use a ‘guaranteed stop loss’ which gets you out of the trade at the desired price.

This facility is only available to people trading the markets via contracts for difference or spread betting, which are very high risk activities. To give you an example of the associated costs, trading platform provider IG says it charges 0.3% of the underlying transaction value in order to have a guaranteed stop loss.

Another issue may be a short-term market shake-out triggering your stop loss, only for the shares to recovery in the subsequent days and weeks. That locks in a loss that might have been ridden out in time.

IT consultancy FDM (FDM) is a classic example. In March 2016, we flagged the shares at 539.5p. In June 2016 the Brexit result sparked a massive sell-off in the share price, falling to 432p.

Anyone who bought FDM at 539.5p and had a 10% stop loss would have had a sell order triggered at 485.55p and missed out on an impressive and rapid recovery. Yet half year results in July bolstered confidence and the recovery accelerated, the stock hitting 654p by early August. FDM has subsequently risen further.

Who should use stop losses?

Chris Beauchamp, chief market analyst at IG, says anyone trading the market on a short-term basis should use stop losses. As for longer term investors, their usage is more open to debate.

You don’t want to get needlessly pinged out of an otherwise sound investment simply because the market has run into a spell of volatility.

Investors who like the idea of stop losses might look at a one-year share price chart to get an impression of how volatile a stock might be and set a stop loss level accordingly.

Other forms of  ‘protection’

A few investment platforms offer trailing stop losses which protect gains by enabling a trade to remain open and continue to profit as long as the price is moving upwards. The trade closes out if the price falls by a specific percentage or more.

More common is the ability to place a limit order. This is an order to sell – or buy – a share, investment trust or exchange-traded fund at a specified price or better. In terms of selling a share, it tends to be used as a way to lock in profit rather than minimise loss.

For example, you might have bought a company at 400p and the highest price at which it has traded over the past 12 months is 500p. You might set the limit order to sell the stock at 505p in the hope that the shares will break that 12 month record in the near future. The limit order means you will sell at 505p or more.

The price at which you sell depends on the best possible price obtained by your broker once they’ve got the instruction to sell.

Please note that your broker won’t guarantee they fulfil your limit or stop loss order; as it all depends on market factors such as liquidity.

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