A stop-loss order is an order with a broker to sell stock at a certain price. If you own 100 shares of ABC stock that is trading at $10 per share, you might place a stop-loss order to sell if it goes down to $9 per share. This limits how much you can lose on the stock.
If the stock never goes down to $9, then the stop-loss order is never triggered. But, if something happens that causes ABC stock to fall very quickly, your stop-loss order may get triggered at a price below $9. But, most of the time the sale occurs at roughly the price level you pick.
On the surface, this seems like a good idea. You are limiting your losses to 10%, and there is unlimited upside. Would a competent stock picker use stop-loss orders? I’ll show that the answer is no.
A competent stock-picker is someone who is able to evaluate companies and identify one or more businesses whose future prospects indicate the stock is underpriced. Suppose that Carl is a competent stock picker and he has identified ABC Company as a business whose stock is underpriced at $10. He expects a significant stock price increase over the next 3-5 years.
If ABC stock drops to $9, Carl wouldn’t be concerned because he believes that the business is doing well and that the market just hasn’t caught on yet. Rather than selling his stock, Carl is more likely to buy more at the lower price.
Stop-loss orders simply make no sense for Carl. He buys and sells based on the attributes of the business relative to its current price. Why would he sell at a price that he judges to be too low? Carl is more likely to sell if ABC stock runs up to $30 without any real justification.
Does this mean that you should always buy more when your stock goes down? Absolutely not. Sometimes a stock drops because of very bad news. Carl may choose to sell ABC after a price drop if he thinks the news seriously affects ABC Company’s long-term prospects as a business.
Few people fall into the category of competent stock pickers. If you still like the idea of stop-loss orders, then this is a good sign that you’re not in this category.