Stop-loss order no cure-all

6/23/2008


Stop-loss orders, which allow you to automatically sell a stock if it drops to a designated price, sound like a no-lose proposition. Few things are more important to long-term investment success than avoiding big losers, and stop-loss orders can help ensure you sell before a stock does major damage to your portfolio.

Let’s say you want to take a flyer on a recovery in Citigroup ($20; NYSE: C). You think the stock could rally 50% with some good news on the economy and housing market, but you’re scared of being hurt by another wave of bad headlines. By placing a stop-loss order at $18, you can limit your potential loss to 10% without sacrificing any upside potential.

A trade with 50% upside and 10% downside sounds like a good deal — and it is, depending on the stock’s likelihood of reaching your upside and downside targets. But just as there are no free lunches, you can’t improve your expected return simply by determining your maximum loss in advance.

All else equal, Citigroup is far more likely to go down 10% than it is to go up 50%. If all else is not equal — and you have a strong belief that Citigroup is headed higher — do you really want to sell just because it is down 10% from your purchase price? If the answer to that question is yes, if a 10% decline is enough to make you question your bullish thesis on Citigroup, a stop-sale order at $18 makes sense.

In general, stop-loss orders make sense when a stock’s price action is paramount in your decision to hold or sell. Such orders don’t make sense as a generalized insurance policy for your portfolio, as placing stop-loss orders on all your stocks will often cause you to sell at the exact moment you should be buying.

To evaluate the impact of stop-loss orders, we created hypothetical portfolios using stocks in the S&P 1500 Index, beginning in 1994. Portfolio No. 1 bought all the index’s stocks and held for 12 months. Portfolio No. 2 sold any stock down more than 15% from the initial purchase price at the end of the first month, then rebalanced into the remaining stocks. This process was repeated at the end of the second month and all future months.

Extending this process through May 2008, portfolios No. 1 and No. 2 delivered similar average 12-month returns before transaction costs, as shown in the table below. We also constructed portfolios that sold stocks based on 10% and 5% declines. Using a sales trigger of 5% boosted average 12-month returns by about 0.5% relative to the portfolio with no stop-loss orders, but using such a tight stop would have resulted in sharply higher trading costs.

While the impact on average returns was modest, stop-loss orders did lower risk. Relative to the buy-and-hold portfolio, all the portfolios employing stop-loss orders had lower risk as measured by standard deviation, worst 12-month performance, and percentage of losing 12-month returns. Stop-loss orders were most effective in down markets.

The bottom line: Using across-the-board stop orders is unlikely to boost your returns. However, stop-loss orders can help limit risk, and using such orders on an individualized basis can make sense. Keep the following tips in mind:

  • When the stop price is reached, a stop-loss order becomes a market order. For example, if you place a stop at $18 and a stock opens at $12 the next morning, you will sell at $12. You can instead use a stop-limit order if you want to sell only at $18, but your order may never be executed.
  • Consider a stock’s typical volatility when deciding on your stop price. If you set a stop 5% below the current price on a stock that often moves 10% in a week, you are very likely to sell at a 5% loss.
  • Your initial purchase price is not necessarily relevant, so consider raising your stop as a stock advances.
  • Before setting any stop-sale order, ask yourself a couple of questions. With nearly 5,000 U.S.-traded stocks from which to choose, does it make sense to own a stock that is only a 10% pullback away from being a sell? Instead of placing a stop-sale order, would you be better off selling now and putting the proceeds into a stock you truly like?

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