Stop-Loss Orders Can Still Backfire on Wary Investors
When you buy a stock, your goal is to make money, naturally. But at the very least, you hope that if you’re wrong about the stock, you can avoid losing too much money before you see the error of your ways and sell out.
One of the most popular tools that some investors use to avoid stock disasters is the “stop-loss” order: You leave a standing order with your broker that a stock be sold if it at any time drops to a preset price. You can do so with any New York Stock Exchange or American Stock Exchange issue; however, there is no formal stop-loss setup for NASDAQ issues, which make up the bulk of smaller stocks.
In theory, stop-loss orders make a lot of sense--especially in markets as nervous and vulnerable as this one. Without having to monitor your stock minute by minute, you’re protecting yourself from a disastrous plunge by keeping an automatic sell trigger set.
In practice, though, stop-loss orders can pose big problems. The worst-case scenario occurred last Thursday, when the New York Stock Exchange unilaterally canceled all stop-loss orders on shares of Costa Mesa-based drug and biotech firm ICN Pharmaceuticals.
The NYSE said so many ICN shareholders had put stop-loss orders in place, the stock was threatened with a selling avalanche if it began to pull back. Ironically, the NYSE’s action caused a selling panic anyway: ICN plunged $4.25 to $12.25 on Friday, after the NYSE decree. It has since rebounded to $14.75 as of Tuesday.
ICN is a strange case, because the stock has a history of crazy volatility. And in the NYSE’s defense, it doesn’t make a habit of canceling stop-loss orders. A spokesman said he believed that this was the first such incident since 1989.
Nonetheless, the ICN mess undoubtedly caused some investors to rethink stop-loss orders.
The biggest risk with a stop-loss order is in setting the trigger price too close to the stock’s current price. If the stock dips even momentarily to your trigger price, your broker is obligated to sell you out--even though the stock’s swing may be nothing but a brief flutter.
Many professional traders, such as Tony Chmiel of AIQ Systems in Incline Village, Nev., advise setting stop-loss orders 7% to 10% below your purchase price. That range of acceptable loss on a stock is practically set in stone for veteran traders, who operate according to one cardinal rule: “Cut your losses, but let your profits run.”
The problem with that 7% to 10% stop-loss rule is that many stocks today swing by that amount or more in a few days’ time, even while their general trend remains strongly bullish. “A lot of stocks that have moved down have come right back up again,” notes Alan MacGregor of investment firm MacGregor-Rodman Investment Management in Westlake Village.
The accompanying chart shows a few examples of stocks that dropped sharply in October, only to soar to new highs recently. Shares of Pasadena-based mortgage banker Countrywide Credit Industries, for example, tumbled from $34.50 on Oct. 15 to $29.625 by Oct. 28, a drop of 14%. But the stock has since zoomed to new highs, closing Tuesday at $39.125.
An investor who set a stop-loss of 7% under Countrywide’s Oct. 15 price would have sold at $32. Meanwhile, an investor who bought at $34.50 and stayed put would now have a paper gain of 13%.
Because of that kind of volatility--especially in stocks still considered to be market leaders--some traders say it now makes more sense to set stop-loss orders near a stock’s “technical support” level, rather than at an arbitrary 7% to 10% below your purchase price.
A technical support level is the price range where buyers tend to reappear in large numbers when a stock drops. Why they return at one particular price rather than another may only be known to the market itself, but the fact is that it happens. (If you don’t yourself know how to read a stock’s chart for such technicalities, you’ll need a broker’s help.)
“If a stock violates its support level, then we sell,” says Harold Parker Jr., a broker at Smith Barney, Harris Upham & Co. in downtown Los Angeles. The reasoning is that, if buyers suddenly fail to show up where they always have in the past, something may be very wrong with the stock.
Generally, many experts say there’s nothing wrong with the concept of stop-loss orders. But most suggest that, rather than formally leaving a stop-loss with your broker, you simply do what NASDAQ stock owners are forced to do: Make your stop-loss orders mental. If one of your stocks falls 10% from what you paid, reevaluate it. If the drop amounts to mere profit taking in a nervous market, there may be no reason for you to exit.
True, mental stop-loss orders won’t help you if a stock plunges in a matter of hours, and you don’t find about it until after the fact. But if a stock is collapsing, a formal stop-loss order may be useless anyway: Your broker can’t sell the stock until someone steps up to buy. If your stop-loss order is at, say, $45, but no buyer appears until the price hits $40, that’s the best price you’re going to get.
The Risk of Stop-Losses Many investors believe it’s smart to set “stop-loss” orders on shares they own, so that a stock is automatically sold if it falls a set percentage--say, 7% from the buy price. But many stocks that slumped more than 7% in October have already zoomed back to new highs, or nearly so.
Oct. Oct. Pct. Tues. Stock high low drop close Countrywide Credit 34 1/2 29 5/8 -14% 39 1/8 First Finl. Mgt. 47 7/8 39 -19% 46 7/8 Merrill Lynch 52 47 5/8 -9% 56 3/4 Value Merchants 38 32 3/4 -14% 42 Wal-Mart 49 5/8 45 1/4 -9% 50 7/8
All stocks trade on NYSE except Value Merchants (traded on NASDAQ).
