If you ask anyone other than me what the main purpose of a stop order is, they’ll say it is to ‘stop a loss’. Hence the fact that the terms ‘stop losses’ and ‘stop-loss orders’ are usually treated as entirely synonymous with the more generic term ‘stop orders’.
Well, I think that those people are missing a trick because … stop orders are not just for stopping losses.
In my book – and I mean this literally as well as metaphorically – stop orders are just as useful (if not more so) for locking-in profits and freeing-up funds.
But let’s start with the more usual case.
Every trader knows that he (or she, I’m not being sexist) should cut his losses; which is very sound advice if you bet the farm on a single stock or other financial instrument and you see your £100,000 life savings ebbing away before your very eyes.
It’s better to cut your loss at 10% down than to hold on for a loss of 50% down … or even more.
But taken to its logical conclusion, it is tempting to think that any stop-out is a good stop-out, and to suffer a death by a thousand cuts. I know I once did!
Suppose you invested your £100,000 as £10,000-a-piece in each of ten stocks that were trading at a mere 1/10th of their all-time high prices.
With diversification and prudent position sizing taking care of the downside risks, and with the potential upsides far in excess of the downside risks, what’s the point in ever stopping out for a loss on any of those positions that could subsequently recover?
There must be better uses for stop orders, such as …
Now suppose that one of your stock positions appreciates by 50% to be worth £15,000 compared with the £10,000 you invested.
You could take some money off the table, but it would be shortsighted considering your original ten-bagging upside potential. So how about you place a stop order to take you out of position if the value of the position falls back to £12,500?
You are assured* a reward of at least £2500 while allowing the position plenty of wriggle-room to become the ten-bagger that you hope it will. If the price goes higher, you trail the stop order in tandem (not too tight) to lock in an increasing amount of profit.
* only strictly true if you can apply a ‘guaranteed’ stop order
This use of stop orders to lock-in increasing amounts of profit is much more interesting to me, and it means that you never stop out at a loss!
Freeing Up Funds
Whether you use them to stop losses or to lock-in profits, you will find that a spread betting company very often grants you more ‘trading funds’ whenever you apply a stop order to a position that didn’t previously have one.
If you manage to place a stop order at break-even on a position that previously implied a risk of £10,000, you have effectively freed-up the original £10,000 worth of risk capital to be deployed again … without having close the original position at all. This is only strictly true if your break-even stop order is guaranteed, but in any event it’s notionally true as long as you are sufficiently diversified.
A conventional stockbroker usually won’t grant you any more funds to play with merely because you reduced your risk or locked-in some profit with a stop order. But you can be more confident about depositing an additional £10,000 of your own money with the broker (if you have it) each time you have notionally freed up that amount of risk capital with a break-even-or-better stop order on an existing position.
So there we have it: two of the lesser-known uses for stop orders that you might not have thought of.
It amuses and sometimes even annoys me slightly when I read articles about how best to use “Stop Losses”. They’re missing the point, because stop orders are not just for stopping losses.