Way to use stop-losses and take-profits

by Jonathan Adams

If you buy and sell company shares, a stop-loss can strategy can minimise risks of falling prices. It is done by instructing your broker or online share dealing platform to sell the stock automatically as it reaches a specific price. This way, you are out of a company before its value goes down.

As for the question, whether investors should use stop-losses as standard, the answer is in affirmative as there is consensus among expert traders regarding it. If used in the correct way, a stop-loss will protect you against being wiped out when the market goes downwards. However, care should be taken. But the use depends on your investment policy. They are must for day traders or those who buy and sell daily.

It is same for those using spread betting or leveraged accounts and who can lose more than their initial investment without automated protection. But buy-and-hold investors or those who like long-term business case of a company and can withstand usual ups and downs of markets should be more conservative in their approach towards the use of stop-losses.

This is because you incur a trading fee every time you sell shares which are normally around £12.50. You do not want to pay this just because a company’s valuation has slipped a little, only to recover the next day. You will then have to pay the transaction fee again to buy back in.

Therefore, long-term investors should set their stop-losses at a level that allows for normal market volatility. For investors who do wish to employ stop-losses, there can be a number of strategies. Investors can set a stop-loss at a particular price or at a percentage of the share price when they invest.

These should be calibrated carefully. Consider a stop-loss that kicks in when a share price dips 5 per cent. If it is fairly common for that stock to suffer downward swings of 10 per cent, the commission from the sale will make the broker richer than it will leave the investor safe.

An alternative tactic is to look at a one-year share price chart of the stock you intend to trade, and set your stop-loss just below a recent low. Whichever approach you like, stop-losses should be fixed with an eye on how much of your capital you are prepared to risk. A handy rule of thumb is to set the stop-loss so that you never lose more than 1 per cent of your capital on a single trade.

Many practitioners recommend what is called a ‘trailing stop’. Trailing stops are simply stop-losses that rise automatically when the share price rises. Every time the share hits a new high after the order has been placed, a new sell price is set. As the price rises, so does the level of gain that is locked in. Although stop-losses give you a measure of security, there is no guarantee they will be executed at the price requested. The great risk is that the market ‘gaps’, which means a stock jumps from one price to another without hitting the intermediate points. Such gaps happen when trading opens if there have been movements in other markets. They result in the transaction being processed at the closest available price, often on less favourable terms than requested. Guaranteed stop-losses can guard against this.

With these, your broker takes on the gap risk instead of you. But the broker will charge you for this, so check the fee structure carefully. Essentially, it is an insurance product, so read the broker’s small print to see if there is really a firm guarantee or whether it’s on a broker’s ‘best endeavours’ basis. Related to stop-losses are take-profits. Rather than dumping shares when they hit a floor, take-profits automatically sell the stock when it hits a ceiling. Since take-profits limit gains instead of losses, not all investors like the idea. But they can be helpful if you think a share price will only hit a peak briefly and you want to sell as soon as it does.

One technique for take-profits is the ‘two for one’ rule. If you buy a share at £1 and set a stop-loss at 90p, for example, your take-profit should be at least £1.20. If you think the likely risk is more than half the probable reward, you shouldn’t be making that trade in the first place. Perhaps the biggest reason why stop-losses are popular with traders is that they help keep decisions rational rather than emotional. Stop-losses help traders plan their entrances and exits beforehand and make reasoned decisions as against the frenzy of the market.

This article is for information purposes only.
Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.
There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.

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