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When to use a stop-loss

Are stop-loss strategies a good way of deciding when to sell an investment?
September 21, 2017

Figuring out when to sell an investment can be difficult. So it’s understandable that many investors decide to simplify the process by using a stop-loss order. This is an order placed with your broker to automatically sell a security if it falls below a certain price.

As the name suggests these orders are designed to limit your potential loss on an investment. For example if you have set a stop-loss order for 10 per cent below the price at which you bought a security, the order should limit your loss to 10 per cent, even if the asset were to fall further.

 

The advantages

The potential downside protection that stop-losses provide if the market falls are their main attraction. These orders can also help take the emotion out of investment decisions, especially if you are a risk-averse investor who is more likely to worry about large losses.

"Stop-losses do have a place in a trader’s investment armoury," says Lee Wild, head of equity strategy at Interactive Investor. "People are always queuing up to tell you when to buy, but very few tell you when to sell. If you're a short term-trader or a beginner investor, these instruments can be useful. Also if you don't have the time to keep an eye on your investments, putting in a few stops on [assets] that you’d be worried about can help your peace of mind. And stop-losses can help if you do lack discipline in your investing strategy."

 

When to use stop-losses 

Investors Chronicle’s economist, Chris Dillow, uses the 10-month average rule to decide when to sell and buy back into an asset. This rule suggests that you sell an asset when it has dropped below its 10-month (or 200-day) moving average and buy back in when it is above its 10-month moving average. He says this rule is effectively a stop-loss strategy, as when an asset falls substantially, for example by at least 10 per cent (a level where stop-loss orders are often set), it will typically fall below its 10-month average too.

Stop-loss orders and the 10-month average rule work particularly well within assets that are more likely to be affected by momentum. This can be either positive momentum, where asset prices that are already rising continue to rise, or negative momentum, when assets that are falling in price continue to fall.  

"Stop-losses work for some asset classes but not others," Mr Dillow says. "The question we should be considering is ‘Does a fall in prices lead to a further fall in prices?’ If it does, then it makes sense to use a stop-loss as doing so will get you out of a bear market early.

"But, on the other hand, if prices follow a random walk (as modern theory suggests) then it doesn’t matter if you use a stop-loss as prices can go in any way. If prices mean revert, then stop-losses are also unhelpful as they may get you out before a recovery."

Mr Dillow would consider using stop-loss orders when investing in Alternative Investment Market (Aim) stocks and also when investing in sectors such as mining, technology, biotech, emerging markets and smaller companies.

"What they all have in common is that they are assets that are quite hard to value and prone to sentiment swings. That’s the sort of asset that is prone to momentum," he explains. Other assets are less prone to momentum, making stop-loss orders a less appropriate strategy to use. Large, well-known and well-researched stocks, which are easier to value, fall into this category.

Mr Dillow says: "If AstraZeneca (AZN) or Diageo (DGE) were to fall in price, that fall would quite quickly be embedded in the market and you might well get value investors diving back in. The efficient market hypothesis [which says it is impossible to beat the market because share prices always reflect and incorporate the available information] is likely to apply to those companies as they are large, well-known companies."

Those with shorter time horizons, such as people who are getting close to retirement, may also want to consider using a stop-loss strategy.

"Warren Buffett says rule number one in investing is don’t lose money and rule number two is don’t forget rule number one," says Russ Mould, investment director at AJ Bell. "Although stop-losses need to be used with care, they are clearly there to protect your downside and restrict your losses."

Stop-losses can also come in handy when investing in more cyclical assets, he says, and are of particular value to shorter-term traders and those using leveraged instruments.

But Mr Dillow believes stop-loss strategies such as the 10-month average rule should not just be considered a tool for those investing for the short term. He says: "The 10-month average rule works for a long term investor because we know that at some point there will be a severe bear market. And buy-and-hold strategies will cost you a lot of money in those rare events. That’s when the stop-loss comes into its own as it saves you from the really severe losses that might come once every decade."

 

Not just for share dealers

Traditionally, stop-loss strategies have been used when trading equities. "Equities are the home of the stop-loss because of the liquidity and potential for prices to rise or fall reasonably swiftly," says Mr Wild. "To take an outrageous example for the sake of clarity: you wouldn't set a stop-loss order on your house or commercial property."

But investors buying and selling investment trusts and exchange traded funds (ETFs) could use them too. Mr Dillow says he would apply the same 10-month average rule to investment trusts and funds in the areas that are more likely to be driven by momentum.

“The price of an investment trust can move either through a fall in the net asset value (NAV) or because investors don’t like the sector any more, so the discount widens. If the discount widens because investors don’t like the sector any more that can be a sign that they are irrationally pessimistic – in which case it’s a buying opportunity.

"But if there’s a fall in NAV it could be a sign of a momentum-driven bear market. Because if an asset is hard to value, investors are likely to look at what other investors are doing. If other investors are selling, they will take that as a sign to sell too."

Meanwhile, Mr Mould argues that you can apply the same principle of stop-losses when trading ETFs too. He says: "You might think that an index is not going to go down 10 or 20 per cent, but it’s perfectly possible and we have seen it happen before on an intraday basis. It will depend on your risk tolerance and pain threshold. If you’re a long-term holder, you would probably be happy to sit it out."

 

Stop-loss disadvantages

But there are risks with using a stop-loss strategy. For example if a stop-loss order you have put in place to sell out at a particular price is triggered but shortly afterwards the asset recovers, you will miss out on any gains.

"Markets can be irrational," says Mr Mould. "If a share price goes back up for no apparent reason soon after your sell order has been triggered you could be locking in a permanent loss of capital. In which case you would have crystallised a loss and that capital is gone."

You could also end up having to pay capital gains tax (CGT) if your forced sale means that you crystallised gains. If you had not sold out, however, you could carry on deferring paying CGT by continuing to hold the assets.

You should also consider the costs of dealing in and out of investments when using stop-loss orders. Platforms and brokers charge around £10 per trade to buy and sell shares, exchange traded funds and investment trusts and so the costs of trading can add up.

And if the asset in question is one you plan to hold for the long term then using a stop-loss order can be counterproductive as you could end up selling at the lowest point and buying back in at a higher price.

Danny Cox, chartered financial planner at Hargreaves Lansdown, says: "A share might fall in value, but if you’re buying and holding I don’t think you should be using stop-losses as the whole reason you’ve bought a share is that you’re confident of the share price rising."

He adds that most people who plan to buy and hold a security would not be hugely worried by a short-term loss in value and could even use a temporary fall in prices to buy more of the chosen asset at a cheaper price.  

Deciding where to set a stop-loss order can also be a difficult call to make and potentially holds its own risks says Mr Wild. "People often don’t do their homework enough on the technical analysis side of things, which is a significant issue for stop-losses," he explains. "When they buy a share, for example, they may follow a stop-loss strategy blindly by deciding to set it at 10 per cent below the current market price. But that may well be just below a level of technical support [a price that historically a stock has had difficulty falling past] where one would normally expect a bounce-back in the shares."

Another potential problem with stop-losses is that in times of high market stress your order may not be executed at the price you wish. This happened during the financial crisis when share prices were falling fast. For example if an investor had set a stop-loss at £1.19, but the share fell straight from £1.20 to 90p then the stop-loss order would be executed at 90p.   

If you plan to use stop-losses you should check what your broker’s terms and conditions are for using them and the circumstances they will commit to or not commit to executing the order.