Why a Stop-Loss Can Give You a False Sense of Security
People can make investing sound really easy by saying that you can simply put a stop-loss in place in order to minimize your losses and prevent you from losing a significant amount of money. In theory, that sounds like a great idea. After all, how a stop-loss works is that if the share price falls below a certain price point, that can trigger a sell order. You can have the sell order have a limit price, or just use the market price at that time.
However, if you use a limit order then you run the danger that the stock won’t be sold, because if it’s going down or things have turned bad, chances are you’ll just want to go out before things get even worse. So in most cases, you’d use a market order when you use a stop-loss.
Where the stop-loss works
If you’re dealing with a highly liquid stock and one that is fairly stable, a stop-loss will likely work very well for you. If you invest in Apple Inc (NASDAQ:AAPL) ahead of its upcoming earnings and decide to bet that it’s share price will take off after a good report (which happens more often than not) but want to eject out in case things don’t go that well, then you can put a stop-loss in to say if the price of the stock drops 2% then you’ll immediately sell the share.
Where the stop-loss fails
The problem, however, is when you’re not dealing with a stock like Apple and instead might be investing in one that is a big more volatile, or even just one that isn’t a not blue-chip stock. Take for example what happened to Home Capital Group Inc (TSX:HCG) last year.
The stock went off a big cliff, and it fell hard:
On April 25, 2017, the stock closed at $17.09. Let’s say you’re the careful investor that you are, and you have a stop-loss put in at $16. The problem is that the very next day the stock opens at just $10 as concerns about the company’s future send investors into a panic. At $10, your $16 stop-loss would already be triggered and by the time a sell order would be put into place, you’d be out at the single digits.
Stop-losses fail when share prices go over a cliff, and these instances aren’t that uncommon. The dangerous part is that they can come with no warning. No technical indicator, no chart, no ratio, no amount of fundamental analysis and research would be able to prepare you for it.
Another example is Valeant Pharmaceuticals Intl Inc. (TSX:VRX)(NYSE:VRX) and the +20% dive it took a few years ago:
What’s an investor to do?
All you can really do is be aware of the risks and try to avoid investing in risky stocks that are prone to these risks. While technically this could happen to any stock, since after all one big scandal could send any company into a downward spiral, there are companies that are at more risk than others. Companies that are dependent on commodity prices, have high levels of debt, or don’t have a big competitive advantage are just a few examples of where you might be exposing yourself to this type of risk.
Knowing the risk is half the battle, while trying to mitigate it is the other.