A “stop loss order” is simply an instruction to sell something at a predetermined price, in order to prevent larger losses normally. For example, if you bought Stock XYZ at $50/share hoping it would go up, you could also limit your potential loss by instructing your broker to automatically sell the stock if the price dropped to $45/share, a decline of 10%. This happens all the time with stocks and some use it to help keep their emotions in check when investing. It can also help you from losing your shirt.
A Stock Doesn’t Care If It’s Owned, But A Mutual Fund Does
Whether or not you believe in the strategy of using stop loss orders, I was wondering why these types of orders are not allowed for mutual fund holdings. Then you realize that a stock doesn’t care who owns it (or doesn’t own it), but a mutual fund does since there are fees being collected from the holders. The more units, the more fees. If investors were allowed to place stop loss orders on mutual funds, assets under management (and hence revenues) could dry up quickly in certain market conditions. Further, since the embedded trailing commissions to financial advisors who use loaded mutual funds would also drop, how would they put food on the table with the current predominant compensation structure of the industry?
This doesn’t seem to be in the interests of investors first and foremost.
Hmm. It sounds like ETFs have an advantage here.
Preet: How do you usually set stop loss? Do you use technical analysis or just using a fix amount of loss like 10% before selling?
Aren’t you better off selling call options than using stop-loss orders? Same effect, but you pocket the premiums.
@Patrick – not the same effect. A stop loss can trigger the sale of your stock on the way down. A written call can trigger the sale of your stock on the way up.
@Henry – depends on the investor. I don’t think there is a right answer, more subjective. There is also the ability of some brokerages to offer trailing stops – the stop loss order increases as the stock price increases. So if you started at $50/share with a trailing stop of -$5, its initially set at $45/share. If the stock doesn’t reach $45 before it reaches increases beyond $50 to say $55, the stop loss is re-adjusted to be fore $50/share. And so on. This protects against having a stop loss for $45/share and seeing the stock going from $50 to $200 and back down to $45 without every taking profits.
Patrick,
Regarding the call option sale. Yes, you collect premium, but the downside protection is limited to the option premium.
Preet,
Yes, the practice seems unfair, but look at it from the perspective of the mutual fund managers. If they have a bunch of orders to redeem shares on a given day, they can sell some holdings to raise cash – at do it near the end of the trading day.
But if they have stop orders, they may not know if the stop is triggered until after the market closes and the final ticks are in. If a lot of redemptions are triggered by a closing bell gap trade, that’s not fair to the remaining shareholders.
@Mark Wolfinger – there could be workarounds. For example, a dealer notified me that they in fact do have a stop loss order facility for mutual funds. If the previous close triggers the notification, the advisor must get consent to redeem units by 1pm. It’s an automated notification with a manual middlestep required.
Preet,
But that’s hardy a stop order. If I want OUT tonight, what good does it do me if I must wait until tomorrow night – only to see the market take a giant tumble (which is what I anticipated after my stop was triggered)
Regards,
@Mark Wolfinger – you are correct, but I think a lot of people would be okay with a one day lag.
Thanks for sharing such great post, it will surely help me a lot, as i am not having such detailed information about this.