With major markets and indices now having recouped their mid-March COVID-19 losses, investors are reflecting on what can be done to better protect their portfolios in case of a repeat. During those first few weeks, very few companies were immune to the effects of the lockdown and we had to contend with an oil price drop caused by Saudi Arabia & Russia’s over production on top of that. Stop Limit Orders are a simple and often overlooked risk management technique that all investors can readily apply to their brokerage accounts.
It’s a type of order that can be used to buy or sell (in our case sell) stocks and ETFs when the price of a security drops to a predetermined level set by you (the stop price). You also need to specify the stop limit which is the lowest price you are willing to accept when you sell (must be equal or lower than the stop price). Stop Limit Orders allow the investor to lock in a sell price to protect a portion of a gain—or limit the amount of loss—on the security held while also having assurance that the sell price will not be less than the limit price indicated.
Unless you are constantly monitoring your portfolio, using Stop Limit Orders can be an effective way to sell positions when you are unavailable to keep track of them. Whether on summer vacation or in the midst of a busy period at work, you simply might not have the time to follow the markets. Stop Limit Orders take care of that for you.
Another often overlooked aspect is that it keeps emotions out of the investment decision process. Behavioural finance studies have shown that investors can more easily sell an investment with a gain than one that has a loss. Many investors have held onto securities far longer than they should have because they were hoping that their investment would come back. When a security is down 8% in one day because of market volatility, the fear of crystallizing that loss will stop many investors from selling it. Once set, Stop Limit Orders can help keep your emotions out of the equation which can be valuable for some investors.
Certain investors create alerts based on the price or percentage change of their securities and they receive an email notification once the criteria have been met. This still poses issues for them because they might not have access to their smartphone or may be psychologically unable to sell once they have been alerted.
Stock prices fluctuate daily and investors need to set an exit price that takes normal daily price changes into consideration or risk having their position sold too early.
In the case of a panic selloff, share prices can drop sharply thus triggering a Stop Loss Order to sell a security for less than the stop price but more than the limit price. In the March selloff, many stocks bounced off their daily lows and finished the day at a higher closing price. Investors either bought back at a higher price or watched from the sidelines as the price recovered.
As an investor, you can manage some of those situations by identifying core portfolio holdings for which, in the event of a panic selloff, your first reaction would be to add to the existing positions, and deciding how much volatility you are willing to take on for the remaining securities.
Taking into consideration the above issues, most investors would be well served to use these types of orders to better manage the risk to their current portfolio of large and sudden market corrections.
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