Stop, in the Name of Profit
Peter Katevatis - May 18, 2018
The sun is shining, the birds are chirping and you find yourself with a solid portfolio of investments that help you reach your investment goals. What a wonderful moment it is! Then suddenly, with no apparent warning, red numbers start flashing a
The sun is shining, the birds are chirping and you find yourself with a solid portfolio of investments that help you reach your investment goals. What a wonderful moment it is!
Then suddenly, with no apparent warning, red numbers start flashing across the screen. Media pundits prognosticate that the end is near and you get a sinking feeling in your stomach that your well-planned goals will not be achieved. Your portfolio values are dropping and you stop worrying about the return ON your investments and start worrying about the return OF your portfolio.
There are two common techniques that can help limit the losses of an equity portfolio.
The first is the use of Stop Limit Orders. A stop limit order is an automated trade that will sell your shares if the company’s share price drops to a pre-determined level. For example, if the shares of a company are trading at $50 you can put in a stop sell order at $45 to limit any loss to 10% ($5). This gives investors comfort that if we have a 2008-style market selloff you will only be participating in the first 10% of the market dropping. Since there always pros & cons here are a couple cons to keep in mind.
Stop Limit orders can trigger on a market correction and then as the share price surges back up you are sitting with cash earning much less. The other con is that if the shares don’t actually trade at your limit price there is no sale to make. If the shares close at $46 one day, then gap down to $40 on poor news the following day, the stop limit order at $45 would not be filled.
To solve this problem you can use the other technique, be a Put Option Buyer. Put options give the holder the right to sell shares at a specific price for a specific time period. So if you buy a $45 put option until September you get the benefit of insuring your holding for the cost of the option. This creates the same safety as the Stop Limit Order with more flexibility. During periods of low volatility some option premiums can be quite low making this a cost-effective strategy.
Remember, the use of some insurance or stop orders is not always about limiting losses. Sometimes, you can use these strategies on profitable investments so that you can ensure your gains. I have found particular success in trailing stop orders so that your sell limit price rises with the rising price of the shares. This allows you to participate in the long-term uptrend of a growing company and also take profits when the trend turns.
The stock markets and the economy have cycles, always have and always will in the future. You will feel much more comfortable in your investment strategy if you have a plan in place to defend against the negative cycle.