By Javier R. Jimenez
September 2000 - The second quarter of this year was full of surprises for investors. The Federal Reserve Bank, raising interest rates due to inflation fears, and overvalued technology stocks caused the most turmoil. Some investors saw huge technology gains from the previous year cut by nearly half.
What can an investor do to protect his or her stock portfolio in a volatile market? One strategy that comes to mind is the stop-loss order. While there are other strategies that apply, such as asset allocation, dollar-cost averaging, and covered call option writing, I've found that the stop-loss order instills discipline, which is essential to becoming a good investor. It fosters a cost/benefit mentality by designating price targets, or what one is willing to risk for future reward. Furthermore, it's a simple strategy to use.
The stop-loss order is an order to sell stock when a given price is reached or passed, and it is typically used to trigger an automatic sale in the event that a stock's price suddenly declines. A stop order to sell always specifies a price below the present market price. When the stop price is reached or passed, the stop order authorizes the broker to sell the stock at the current market price.
A stop-loss order can be used to limit a loss in a volatile market. For example, say a customer wishes to buy ABC technology at $100 a share and believes the stock is a good buy, but is concerned about the general market's stability. A stop-loss order can be used to limit the customer's loss in a sudden market downturn.
Before buying stock, you should determine a target price on the upside, or whether you'd like to hold on to the stock for a long time on the basis of the fundamentals of the company. At the same time, you should determine a price beyond which you're unwilling to take a loss. Most investors are bullish and typically don't have a downside price target. Generally, I like to have a 10 to 15 percent downside price target. For example, if I were to buy ABC stock at $100 per share, my downside price target would be between $90 and $85 a share. If the stock takes a turn for the worse and the price falls, the stop-loss order becomes a market order once the target price is reached. Taking a loss is never easy, but if the choice is between one of 15 percent and one of 50 percent, I'll always opt for the former.
The stop-loss order also can be used to lock in profits. For example, if you bought XYZ Company at $100 per share and its current price is $200, you could place a stop-loss order at $180 to guarantee profits in the event of a market slide. This technique enables investors to participate in continued growth for as long the stock value climbs without jeopardizing past gains.
I firmly believe buy-and-sell discipline is a big part of becoming a competent investor. Needless to say, you should consult with your financial adviser before implementing this or any investment strategy. There is no guarantee that any strategy will succeed. Furthermore, after-market trading and volume discrepancies can affect the executed price of stocks.
Javier R. Jimenez is an investment executive with Wedbush Morgan Securities. This article is provided for informational purposes only. Its content is based on sources considered to be reliable, but its accuracy is not guaranteed. The information presented is neither an offer nor solicitation of an offer to sell or buy any security that may be mentioned herein. The information and expressions of opinion contained herein are not a representation by Wedbush Morgan Securities and are subject to change without further notice.
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