How to Set Up a Stop-loss System
A stop-loss system is a very useful tool investors can use to prevent large losses on shares and to cement profits that do occur.
Setting a stop-loss means deciding at what point you sell if a share’s price falls. The important thing is deciding at what level of loss to set your stop. This depends on what type of investor you are. People who trade often and tend to hold shares for a short period of time may set the rate at 5%. Longer-term investors may not set a stop-loss until a share has fallen by as much as 15%.
The idea is that if a share price is falling by the set amount, there must be a reason for it. Better to cut your losses now and then buy the shares again at a later date, when they seem to be established on an upward trend again. This way you protect your capital and pick up far more shares for the same money.
Investors need to think hard about what stop-loss level to set. For example, a particularly volatile share might fluctuate by plus or minus 5% on a regular basis. If you constantly sell when the price hits your stop-loss you'll end up eating your capital away through dealing charges and the bid-offer spread (the difference between the buying and selling price).
All investors occasionally pick a dud share and companies do go bust, so it makes no sense to hang on to shares that are falling in value. Although sticking rigidly to stop-losses is one of the hardest disciplines for investors. There will be times when you sell, only to see the share soar afterwards. This is the price you pay for operating a safety net.
Stop-loss orders can also be used to lock in profits. In this case, the order is set at a percentage level below not the price at which you bought the share but the current market price. The price of the stop loss adjusts as the share price fluctuates. Remember: if a stock goes up, what you have is a ‘paper gain’. You don’t get the cash in your hand until you sell. Using a stop-loss allows you to let profits accumulate while at the same time guaranteeing at least some capital gain.
Say you buy stock at 250p a share, and you set a stop-loss at 10% below the current price. The shares then rise to 350p. Your stop-loss would be activated when the shares sank to 315p per share (350 x 10% = 35. 350 - 35 = 315). This is the worst price you would receive if you sold your stock immediately.
Brokers in the UK don’t often operate stop-loss systems on behalf of their clients, so it’s up to you to keep a close eye on your investments. Many websites allow users to set up portfolios of their shares and set alerts. These automatically tell you when your shares fall below a certain point; www.thisismoney.co.uk and www.iii.co.uk are just two of the websites that offer this service.