An easy way to reduce exposure to losses in a portfolio is to use stop losses. Stop losses are orders that instruct your broker to sell an investment when the price drops to a certain level. For instance, an investor may decide to buy a stock at $100, while placing a stop-loss order at $95 to minimise any potential losses. If the stock price actually falls to $95, then their broker would immediately sell the stock.
Stop losses are an easy and effective way to minimise risk, reducing exposure to sharp declines in stock prices. It’s automatically dealt with by the broker, so you don’t have to actively monitor your positions.
As well as using stop losses to avoid losses, stop losses are used by investors to help them to lock in profits. An investor may decide to place a stop-loss order at a certain level of profit, to ensure that declines do not reduce their profits too much.
Placing a stop-loss order is fairly simple. It is usually the case that you would sign in to your online broker account and select the particular investment that you want to set the stop-loss order for. Then, you would select the ‘sell’ option, where the ‘stop loss’ option should be featured. You will usually be asked by your broker how long you want the stop-loss order to last for, as well as what price you would like it to be set at.
A key benefit of stop loss orders is that they usually do not cost any money to use. Your broker will usually just charge you ordinary transaction fees.
The downside of stop losses is that short-term stock market fluctuations can often trigger the stop losses unnecessarily, meaning that investors miss out on capital gains as the market picks up again. For example, if an investor buys a stock at $50 and places a stop-loss order at $49, it would likely trigger unnecessarily as the investor set the stop loss at a high figure. This would be a disaster if the stock then increased in value up to $65.
The investor would have missed out on huge gains after setting the stop-loss order at too high of a price. With such large swings in the stock market, it is not uncommon for stock prices to swing down, only to swing back up to record highs.
Another problem with stop losses is that there is no guarantee that your broker will actually execute the order. If the price of stock declines rapidly, then it means that the broker may not have time to actually execute the stop loss order. This obviously results in the investor potentially being exposed to huge losses.
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