LEVEL: INTERMEDIATE
While portfolio managers will often calculate the level of risk that they are willing to handle as part of their overall investing strategy, executing that strategy is a matter of setting price limits on orders. These limits can be placed when buying and selling a security, and are usually made to create an entry point and exit point that fit an investor’s model. However, models sometimes fail, so investors will also use stop orders to limit the losses they are willing to take in case their models are wrong or the market responds contrary to the investor’s expectations.
Everyone is familiar with the adage to buy low and sell high, but since securities are unpredictable and volatile, investors may often decide that they want to exit a security at a certain point to minimize their potential losses or to keep a portfolio sufficiently liquid. One of the most frustrating aspects of investing is when you buy a stock, it suddenly goes down, and you sit on the stock waiting for it to go up. Sometimes it never does, and your money is tied up when there are other investments that you could be making money on. Stop-loss orders are a way to minimize this eventuality.
Stop and Stop-Loss Orders Defined
A stop order is one of the basic features of investing, and is one of the commonest types of orders that can be made in addition to limit and market orders. A stop order is an order to buy or sell a security the moment that it passes a certain price. A buy stop order will be an order to buy shares after it has gone above a certain price, and a sell stop will be an order to sell shares after it has gone below a certain price.
When it comes to executing a risk strategy, we refer to sell stop orders. These are used by investors to limit exactly how much money they will lose on a particular investment, and can be made immediately after a security has been purchased or at some later point. Several investors, especially when it comes to particularly volatile stocks, will place stop orders a few days after purchasing the security. This is because the stock might temporarily go below the set stop price, liquidate, and then return above the stop limit, causing the investor to lose money for no reason. These types of swings are common shortly after buying a security, so investors will often wait to put stop losses on their investments. Alternatively, they will put in place large stop loss orders at first, then tighten the stop loss order at a later point.
An Example
Let’s say I want to buy 1000 shares of the ticker XYZ for $100 based upon my model, which predicts a 10% gain in XYZ in the upside scenario over the next month. That means I’m expecting the stock to be worth $110 in thirty days or so. However, my model also predicts a 10% loss in XYZ in the downside scenario, and I’m 100% confident in my model (no one ever is, but we’ll discuss margin of error in a bit). In that case, I would set a sell stop order of $89.99, or just immediately below what my downside scenario predicts. In that case, if XYZ falls below $90 I will sell immediately.
Why would I do this? It seems from the outside that I am setting myself up for loss, but what I am actually doing is ensuring that my investments execute according to my model. If my model predicts that the stock will fall by 10% in the worst-case downside scenario and the stock actually falls by more than 10%, it means my model has failed for some reason (or, as some investors like to think, the market is being stupid and not living up to the investor’s model). Thus I will put a stop-loss order on my investment to protect myself from the risk that my model will fail.
Calculating Stop Limits
I have used 10% to make the math easy, but in reality there is no set figure for a stop-loss limit. Some investors will habitually set a stop limit at a certain rate—say, at a 10% loss. Others may have different limits for different markets, sectors, or according to other variables as appropriate for their risk model.
When deciding on what stop limit to set on your purchase, your model should be your guide. Most investors will look at the lowest possible loss predicted by their model and set a stop-loss at a level lower than that. How much lower? It depends on how you define your margin of error.
For example, let’s say you want to invest in Apple. Your downside scenario suggests the stock might fall by 10% in the next two months based on systemic risk and market risk factors. However, you also believe your model has a margin of error of 5%. That would mean your downside scenario could predict the stock will fall as low as 15% in two months, so your stop loss should be lower than that. Some investors will add a “just-in-case” buffer, so perhaps you would set a stop-loss of 18% in this case.
Stop Orders on the Zolio Platform
The Zolio platform allows you to make market, stop, and limit orders both when buying and selling securities, so you will be able to execute your risk strategy when trading on Zolio. It is important to check and double check your orders on Zolio; typos have cost banks billions of dollars, and can ruin an otherwise flawless portfolio strategy, no matter how big or small of an investor you are.