It's the classic evasion of reality. We own a losing stock that continues to drop. But rather than sell and take the loss, we stubbornly hold on and wait for a bounce that never comes. The only thing worse would be doubling down along the way.
To stem this familiar scenario, traders rely on the stop-loss order, an order to sell shares you own below the current market price, should that level ever be hit.
It serves a practical purpose, to cut losses short, but also a psychological one. The reason stop-loss orders work is that they are actually executed; unlike the "mental" orders we often mark in our brains but never pull the trigger on in our portfolios.
But everything that makes the stop-loss order so useful also holds true for its mirror image, the buy-stop order, which ironically most investors never consider using at all.
A buy-stop order is entered for a security you don't own at a price above the current market. Once your specified price is breached, the shares are purchased.
What makes buy stop orders effective is that they are triggered by the market's only important indicator, price.
It's always a little bewildering that upon coming across a stock we want to own, our first instinct is to wait for it to fall so we can buy it cheaper. You know the drill: XYZ is at $35.10, but you're going to hold off and see if you can pick it up at $34.85.
But if you're bullish on XYZ, you want the stock to rise, not fall. Buy-stop orders allow you to be first in line to participate in that move as soon as the market confirms your outlook.
Using them truly puts you first in line. Even with today's instantly disseminated quotes, it still takes investors time to see a price, analyze how it might fit into their portfolio, and actually call or log-on to their accounts to place the trade. Buy stop orders mean you've already executed by the time most investors are just firing up their E*Trade (ETFC)
In addition, just like stop-loss orders, buy stops instill a discipline that prompts one to act even when emotions get in the way.
Consider that stocks just finished out their best first quarter in 14 years, with the S&P 500 rising 12% from roughly 1260 to 1408. As we've written about over the past few months, fund flows suggest many individual investors have missed the rally, instead allocating assets to bonds, which suffered their worst quarter in 2 years.
That's the emotional risk: regardless if it's Apple (AAPL)
Buy stop orders put aside fundamental considerations like earnings, management or analysts' opinion. They don't succumb to our fears over "buying the top" or of having "already missed the move". They act when you should want to: when the market is proving you right.
Where to place a buy-stop order, however, differs slightly from a sell-stop in that you don't already own the shares. With sell-stops, many investors stick to a fixed loss on their initial investment. If the stock ever declines 15% below their purchase price, for example, they're out.
With buy stops, we don't have the objective measure when determining where to place an order.
So do you put buy-stops 1% higher than the current market price? Five percent? While specifics will depend on each individual's portfolio, timeframe and risk tolerance, I believe the idea is to place the buy stop at the cusp of what you see as a new, higher trading range for XYZ.
Long equity investing means looking for a fundamental revaluation of an asset. Whether it's gold going from being frowned on to gorged upon or Latin American stocks transitioning from being avoided to embraced, the idea isn't to grab a quick scalp, but to participate in a longer-lasting trend.
To that end, I look to put buy stops where a market would begin to break out to higher, often historic or uncharted levels -- the places your gut would tell you to dump shares, not buy them.
Like an artist or inventor, this involves investors being able to imagine something new: namely a trading range or valuation that does not yet exist.
The buy-stop order works because it purposefully puts us in the market exactly when that transformation in the midst of occurring: when what we had imagined beings to actually become real.—Jonathan Hoeing is managing member at Capitalistpig Hedge Fund LLC