A Word or Two About Stop Limits

After our last PAYLOAD STOCKS Hotline update, we received a barrage of calls from our subscribers, asking questions about the content of the update, as well as about the service itself. We thought it might be a good idea to address some of these issues in Profit Confidential, as well as in our next PAYLOAD STOCKS newsletter, in case there are others with questions as well.

In the recent Hotline update, we simply stated that no changes were made to our portfolio, but that due to almost two weeks’ worth of selloffs, a few of our stop limits were triggered, resulting in losses. To our surprise, first thing Monday morning, we got quite a few calls and emails, in which subscribers wondered how come they didn’t receive any sell alerts and why they were not notified in advance about the triggers. This made me realize that perhaps part of the problem is that I have not adequately explained what stop limits are, how they work, and what their purpose is when buying a stock.

But, first things first! PAYLOAD STOCKS is a service where we sift through countless press releases, articles, internet blogs, etc., looking for small- and micro-cap companies that might have potential for significant, short-term returns. When we are satisfied the company has potential, we issue a Highly Speculative Buy alert. Now, it is very important to emphasize that all our “Payload Stocks” are Highly Speculative Buys. This means that although there is great potential for significant returns, there are also significant risks involved, which is why we have labeled those stocks as ‘Highly Speculative.’

Now, because our “Payload Stocks” are recommended as Highly Speculative Buys, we also always urge our subscribers to protect themselves by casting the safety net with something called a stop limit. Stop limits are a smart way to limit your losses in case the market moves against you. For example, you bought a stock at $5.00, and just in case, you placed a stop limit 20% below your purchase price, at $4.00. So, not only did you buy the stock you wanted, but you also built a protective measure right from the start.

How much below the purchase price you should place the stop limit will depend on how much risk you can tolerate. More conservative investors may place their stop limits much tighter, while speculative investors are okay with a wider spread. In case of our “Payload Stocks,” we typically recommend a stop limit be placed at 20% and that highly speculative stocks do not take up more than ten percent of your overall portfolio.

Now, let’s return to the example above for just a moment. Let’s assume that for a couple of weeks after you placed your buy order, the stock performed well. But, then the overall market went through a correction due to a whole slew of factors, such as geopolitical instabilities, weak economic data, poor outlooks, etc. Suddenly, there are more sellers flooding the market than buyers. Sometimes, we refer to this market condition as the “selloff.” As a result, your stock’s price took a beating, falling below $4.00. But, you’re okay with that, because your losses are limited to the 20% of the original investment.

But, there is a catch with stop limits–even if the stock dips below your stop limit for just a minute and bounces right back up, a sell order has been automatically created. At this point, you can cancel it only if you immediately call your broker and if the sell order hasn’t been filled yet.

Since a stop limit is an automatic feature that you have set up at the onset of your buy order, we cannot issue a sell alert to warn you about it. The first reason, as already explained, is that once a stop limit is trigger, the sell order is automatic. The second reason is that we are inherently bullish about our “Payload Stocks” and we don’t want to sell them. However, we like to play it as safe as possible as any other investor. And, if we have to lose money on a trade, we’d rather our losses are limited according to our risk tolerance level.

One more thing you should be aware of with stop limits. Not every full service broker is crazy about clients who constantly place orders with stop limits. It requires extra work to monitor numerous stocks in just as many, if not more, accounts, for who knows how many clients. However, it is your right to ask for a stop limit, especially if a stock is of more speculative nature.

In addition, some brokers may not even have technical abilities to place stop limits on stocks trading in certain markets. For example, during my broker days, the firm I worked for did not allow stop limits on stocks that trade on the NASDAQ. The reason was that the NASDAQ is a fast and highly liquid market, in which having automatic orders, such as automatic sell orders after stop limits are triggered, could result in a conflict with a number of superseding regulatory requirements. For example, in a fast market, automatic orders may screw up the priority of other client orders and potentially lead to unwanted cancellation of a string of trades, or worse, to manipulation.

So, what are you to do if you cannot, for whatever reason, build a stop limit into your buy order? Well, you might want to go with a different broker, or monitor your investments closely, especially price movements. And don’t forget, ups and downs are part of normal functioning of capital markets.

I believe this article has overreached its format, so I will have to stop here. However, for subscribers to my PAYLOAD STOCKS newsletter, in the September issue I will discuss in more detail stop limits, and other issues that have been brought to my attention concerning the mechanics of trading small- and micro-caps.