Explaining stop losses and how they work
The risk of loss is a reality for all investors so using a stop loss to sell shares if they fall to a certain price sounds like an ideal solution, but the reality can be different.
Stop losses send an alert to a stockbroker when a share hits a certain price and instructs them to sell the shares on behalf of an investor.
As with the sale of any asset, a buyer is required. If shares are in freefall on the back of a profit warning, for example, it can be difficult to find a buyer at the designated stop loss, potentially leaving investors with a larger than anticipated loss. This is known as ‘slippage’.
Informed Choice Independent Financial Planning spokesman Martin Bamford says stop losses are mainly used by traders and professionals to manage risks when trading on a daily basis.
He argues speed plays a huge role in selling quickly as ‘microseconds actually count’ and these tools offer a safety blanket of sorts, although he stresses stop losses never guarantee selling at a certain price.
Bamford says retail investors generally avoid stop losses thanks to their long-term investment strategy and acceptance that volatility is ‘the price you pay’ for getting involved in the stock market.
BASIC, GUARANTEED OR TRAILING?
The most common form of stop loss is triggered when shares in a company go below a specific level. For example, if you set a stop loss on a share at £1, a request to sell will be triggered when the price goes below £1.
Guaranteed stops aim to ensure your position is sold at the specified level - but this method will cost you extra in the form of a premium charge.
Trailing stops work differently by simultaneously trying to help protect profit and limit losses.
Instead of setting a single sell-out point, several points are set up at a higher level than the original price. If the shares go higher, the trailing stop will move upwards with it.
For example, someone could place a trade on Lloyds (LLOY) at a price of £40.90 with a trailing stop loss of five points (£35.90). If the stock hits £55.90, the trailing stop will then be £50.90.
DO STOP LOSSES ACTUALLY LIMIT LOSSES?
‘Stop loss is a misleading name, it should be named guaranteed loss’, cautions 7IM chief strategist Terence Moll who believes the tool gives the illusion investors can limit their losses.
Share prices generally tend to bounce back within a matter of days or weeks says Moll, although he concedes stop losses are useful for day traders.
Declines in share prices can be a buying opportunity, allowing investors to scoop up more shares at a cheaper price.
If the fundamentals of the business have not changed, Moll says investors may consider topping up their position.
According to Moll, a better approach for investors would be to decide on their own ‘review point’. So, if the shares move higher or slip lower to a certain price, investors should use this as a catalyst to reflect on whether they want to buy, sell or hold their position.
The fallout on 24 June 2016 from the UK voting to leave the European Union exposes how stop losses could in theory do more harm than good.
Car insurer Admiral (ADM) is a prime example of how rash selling can impact investors. The shares slumped 14% in early trading on 24 June – but it did not remain this way for long.
By the end of the day, the stock was only 2.2% lower and was up 5.9% a month later. Investors who had set a stop loss 10% below the previous close, for example would have crystallised a double-digit loss when a recovery in the shares was just around the corner.
Being patient would have paid off with fellow insurer Prudential (PRU), which initially plummeted 17.7% on 24 June but recovered to a dip of just 1.3% a month later.
CAN STOP LOSSES ACTUALLY LIMIT LOSSES?
Naturally there are examples of where a stop loss might have spared you greater pain, shares in embattled Thomas Cook (TCG) were near six-year lows at 37.5p in November, after a damaging profit warning (27 Nov).
Speculation over its financial position and short selling wiped another 15% off the company’s value on 4 December, several days after this warning.
If investors had set a stop loss which was triggered by the profit warning, they would have limited further losses in the short term as the shares eventually fell to a low of 22.7p.
For investors trying to decide whether to use stop losses, you need to figure out whether you have a long-term view and if you are ready to ride out volatility and regularly review when to potentially sell current holdings. If you can do this, stop losses arguably have few additional benefits to offer.