How to Use Stop Orders to Reduce Risk

Financial advisers can help ease investor concerns about staying invested during turbulent times.
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As we’ve seen the markets stage a solid recovery over the past couple of months, advisers may be looking for ways to keep clients invested while minimizing downside risks. One tool to consider is the use of stop orders.

A stop order is an order to sell a stock, exchange-traded fund or other exchange-traded investment vehicle when it trades at or below a specified level. It can also be used when looking to buy shares -- a stop can be set at a certain level triggering a buy order when the shares trade at or above a certain level. Stop orders cannot be used in connection with open-end mutual funds.

Once the stop price is reached, it triggers a market order that will then be filled.

Related Types of Orders

Variations of the stop order include:

Stop-limit orders combine a stop order with a limit order. A limit order limits the price at which the security can be bought or sold. When combined with a stop order, it sets a floor below which the security can be sold, or on the buy side, a limit above which the security will not be purchased. For example, a stop-limit order at $50 per share will be triggered when the price of the security hits that level. In the case of a sell order, if the limit portion was set at $48 per share, the security will only be sold at a price of $48 or higher.

A stop-loss order is similar to a stop-limit order, except that the loss part of the order will set a percentage limit below the level of the stop order below which the security cannot be sold. These are also known as trailing stop orders and the stop price will increase if the shares rise in price but will not be decreased if the share price falls.

Cautions When Using a Stop Order

One of the downsides of using a stop order to limit a client’s downside is that once the stop order is triggered, it will be executed at the next price at which the security trades. In a situation where the price is falling rapidly, the security may be sold at a price that is well below the stop price.

Another scenario to be aware of is when something that impacts the markets in general, or a particular security, occurs after hours. This can cause the markets or the particular security to open much lower than the previous close and could trigger the stop order -- resulting in a sale price significantly under the stop price.

A stop-limit or a stop-loss order can help limit the loss that is realized by selling the security, but your client might still be stuck holding the security at a drastically reduced price if the price of the shares falls so drastically that the trade isn’t executed, or if only part of the trade is executed.

Depending upon the custodian and the exact type of order used, there may some additional provisions that you can place on your stop, stop-limit and stop-loss orders to exert a bit more control:

Fill or kill (FOK) means that if the order is not immediately executed after the shares hit the trigger price, the order is canceled.

Good-‘til-canceled (GTC) keeps the order in place until it is either executed or canceled. The maximum is generally 60 days, but this will vary by custodian.

All or none (AON) specifies that either the entire order is filled or none of it is filled.

Using Stop Orders to Reduce Risks

While stop orders, stop-limit and stop-loss orders do not offer a perfect solution, they can help ease investor concerns about staying invested during turbulent times.

This may involve a change in some of your investment strategies, such as the need to use ETFs in place of mutual funds.

Especially with the volatility we’ve seen in the stock market so far in 2020, stop orders can be a way to limit downside risk for part or all of their portfolio. While the stock market rebound has been gratifying to many investors who suffered losses during the steep selloff we witnessed in the wake of the COVID-19 pandemic, this does not mean that there will not be another selloff or that the market volatility is behind us.

The use of stop orders can make sense for a retiree who needs exposure to equities, but is fearful of downside risk and suffering excessive losses should the market turn down in the next few weeks or months. The stop order, stop-limit or stop-loss provides a trigger to sell some of their holdings at a predetermined level. There is no emotion involved. If the share price reaches the appropriate level, the shares are sold.

For clients who have unrealized gains on shares of individual stocks or ETFs, using a stop order, stop-limit or stop-loss order can help protect those gains. This can allow the client to set a floor on the amount they are willing to see the security fall before selling. It can also take the emotion out of the sell decision and might be the impetus some clients need to take some profits and reinvest the funds elsewhere.

Stop orders and their variations are not a perfect tool and advisers should give consideration to the pros and cons of them in general and for the client for whom they are considering them. They can, however, be a way to reduce investment risk if used appropriately.