What are stops and how should I use them

Every investor wants to take advantage of any opportunity to protect his investments. Investing is a tricky business if you do not know what you are doing. The wise investor understands the risks that should be taken and the security features that can be put in place to ensure a profit. Using stops is an excellent way to have some control over your risks.

In talking about investing, stops are also known as a "stop order" or "stop-market order". When a stop order that has been placed on a security reaches its limit, it means that that security has decreased to a price that is no longer acceptable to the purchaser of that investment. A broker is usually responsible to then sell that security (usually at the prevailing market price). A stop loss order typically has a 10% safety net. In other words, after the low cost limit is set the security can actually go as much as 10% lower than that price before the security is ordered to be sold.

Advantages of using stops



• Stop orders cost nothing to implement. The cost of the stop order is considered part of the commission that is regularly charged by an investment broker.
•  Just as insurance protects you from the unexpected, stops protect your investment from the unexpected turns of the market.
•  If you do loose money, with a stop loss order you loose it at a much slower rate so you have more of an opportunity to make different investment decisions.
•  Stop losses make moving on with your investments more efficient. Often times people get emotionally involved with their investment or believe deep down that the investment will turn for the better. This only worsens your situation as the security will most likely be decreasing more and more while you go back and forth with your decision of what to do.
•  Stop loss orders help you to maintain a clear vision for how you want your investments to work out by setting clear boundaries and making early decisions regarding immediate actions that are most prudent to take.

Disadvantages of using stops



• Stops could be triggered by short term fluctuations in the stock market. Meaning that your stop order could be triggered pre-maturely. To counteract this negative outcome short term investors who are not willing to take on as much risk should set a stop loss order at 5% where longer term investors who are willing to take more risks would be safe in setting a stop order at 15%.
•  When a stop order is reached on a security it automatically becomes a market order (in the eyes of your broker). This means that the security is ordered to be sold at the prevailing market rate. However, there are times when the value of the security with the stop order is still higher than the prevailing rate. You loose money by selling the security for less.
•  Some brokers will not allow you to place stops on certain securities. For example, penny stocks are often denied stop orders probably because it would be too much work for a broker to handle as there are often many constantly fluctuating penny stocks on the market.