A relatively simple, yet commonly underemployed market investing strategy is the stop loss order. It is an order placed with a broker to buy or sell once the stock reaches a certain price. A stop loss is designed to limit an investor's loss on a security position. For instance, setting a stop loss order for 10% below the price at which you bought the stock will limit your loss to 10%. In any form of long-term investing and short-term trading, knowing the right time to exit is just as important, if not more importan than, determining the best time to enter the market.
The most basic technique for establishing an appropriate exit point is the trailing stop technique. Very simply, the trailing stop maintains a stop-loss order at a precise percentage below the market price (or above, in the case of a short position). The stop-loss order is adjusted continually based on fluctuations in the market price, always maintaining the same percentage below (or above) the market price. The trader is then "guaranteed" to know the exact minimum profit that his position will garner.
An obvious advantage of a stop order is you don't have to monitor on a daily basis how a stock is performing. This is especially useful when you are on vacation or having a full time job that prevents you from watching your security for an extended period of time. A stop loss orders have most often been employed as a way to minimize and prevent major losses. It could also, however, be used as a tool to secure profits, in which case it is sometimes referred to as a trailing stop. A stop order is a unique way to minimize emotional responses, which often interfere with execution of a good investing strategy. It is a great compliment to discipline necessary for successful investing plan.
The disadvantage is that the stop price could be activated by a short-term fluctuation in a securities price. The key is picking a stop-loss percentage that allows a security to fluctuate day-to-day while preventing as much downside risk as possible. Setting a 5% stop-loss on a security that has a history of fluctuating 10% or more is not the best strategy: you will most likely just lose money on the commissions generated from the execution of your stop-loss orders. There are no hard and fast rules for the level at which stops should be placed. This totally depends on your individual investing style: an active trader might use 5% while a long term investor might choose 15% or more.
Another thing to keep in mind is that once your stop price is reached, your stop order is a market order, the price at which you sell may be much different from the stop price. This is especially true in a fast-moving market where stock prices can change rapidly.
