Before you think about setting a Stop Loss order, you need to be aware of the drawbacks.
At first, it may seem like the perfect tool to help you avoid heavy losses or lock in gains. However, there are a number of scenarios where a Stop Loss order can punish you.
The Gap Down.
If a stock price gaps down overnight and it falls beneath the value of your Stop Loss, your shares will sell at the opening price.
Unfortunately for you, this price may be well beneath the price that you are willing to sell at.
An example of how a Stop Loss can hurt you.
Let’s take a look at a fictional example.
You have shares in Facebook and the stock price is currently $190 USD.
You’ve done your research and you believe in the future of the company. Your personal prediction is that it will hit $250 within 12 months. You bought those shares when the stock price was at $175, so you’re currently up $15 per share.
Things are going pretty well.
In an effort to try and protect your current profits, you create a Stop Loss order at $185. In other words, if the stock price of Facebook falls to $185 or below, your Stop Loss order will kick in and your shares will sell for a profit.
Unfortunately for you, Facebook CEO Mark Zuckerberg has a big mouth.
After the market closes, he tells an interviewer that the company might reduce the number of advertisements that are shown to users. Zuckerberg doesn’t state that they have immediate plans to do this or anything. He is just saying that it could happen in the future if user engagement falls.
Basically, he is just “throwing it out there” as a possibility.
After Market crash.
As I’m sure you’re aware, a reduction in ads will almost certainly lead to a reduction in revenue. In turn, this would negatively affect Facebook’s profit margins.
These comments spook investors, many of whom have access to After Hours and Pre-Market trading. Upon hearing the news, they sell their shares like there is no tomorrow, and the stock price crashes to $172 in After Hours trading.
Meanwhile, you’re busy painting your bathroom walls a new shade of pink or you’re on vacation in Cancun drinking shots of tequila with your buddies.
As a result, you’re not really paying attention to what is happening with Facebook.
As far as you’re concerned, your Stop Loss is there to protect you and it will kick in if anything goes wrong.
The next morning, the stock price opens at $168 per share and your Stop Loss kicks in. Your broker sells your shares at the best asking price, which happens to be $168 per share. This leaves you with a loss of $7 per share. Damn.
But wait, it gets worse.
As it turns out, investors are emotional creatures who can sometimes overreact to news stories. Eventually, Zuckerberg clarifies that his comments were taken out of context and the stock price immediately starts to rebound.
Unfortunately, by the time you realize what has happened, the stock price is already hurtling towards $177.
However, your shares are long gone because your Stop Loss kicked in and you sold near the bottom.
Another issue is volatility. In other words, how rapidly can the share price change?
Certain stocks are more volatile than others. They can swing up and down by more than 5% in a single day. The share price may fall 7% and bounce off support levels before heading right back up to reach a new all-time high.
If you are investing in stocks that are volatile, a tight Stop Loss can be triggered too easily, causing you a loss.
If the share price of a company is at $55 per share and that company is known to trade between $42 and $62, then setting your Stop Loss at $52 may lead to a quick loss.
In cases like this, you might want to set it at $41, or $61.50 once it has broken through resistance and reached an all time high.