What You Should Know about Stop-Loss Orders for Penny Stocks - dummies

What You Should Know about Stop-Loss Orders for Penny Stocks

By Peter Leeds

Stop-loss orders are preset sell orders (either at the time you purchase your shares or soon after) that are triggered if the penny stocks fall a certain percentage below your buy price. If the most you could ever lose on a penny stock was 10 percent, but your upside gains could be limitless, you would do very well as a penny stock investor.

Stop-loss orders can protect you from shares that fall significantly, while keeping your investments open to huge upside.

Consider a scenario in which you buy shares of a penny stock at $2.15 and then immediately set a stop-loss 10 percent below that — at $1.94. If the shares slide to $1.94 or lower, you would sell the shares, no questions asked, no matter what.

However, if the shares soared toward $10, you would benefit from the gains. And if those same shares topple to 6¢, you will have sold out long before and only suffer a minor loss.

Automatic versus mental stop-loss orders for penny stocks

Some brokers allow you to set up automatic stop-loss orders. If an automatic option isn’t available, you’ll need to do them manually. Here’s the difference:

  • Automatic stop-loss orders: Some brokers will let you set up automated stop-loss orders on some penny stocks, meaning that the stock is put up for sale as soon as it hits your stop price. If this option is available, take advantage of it. Automatic stop-loss orders are more reliable than mental stop-loss orders.

  • Mental stop-loss orders: With this type of stop-loss order, you have a trigger price in mind and sell when shares fall to that level. Make sure to set up a price alert at your mental stop level when you first buy the stock so that you don’t get surprised if the shares start falling.

When your shares hit a mental stop-loss level, selling those shares is one of the hardest things to do in investing. Some investors try to reason their way out of unloading the position, and others justify reasons to keep the investment. For stop-loss orders to be of any value as an investment strategy, you need to stick with the strategy, no questions, no excuses.

How to avoid getting stopped out with penny stocks

One of the biggest risks with using stop-loss orders on penny stocks is the potential of getting stopped out. This refers to a downward price swing, whereby you hit your stop and subsequently sell, just to see the penny stock bounce right back up. Penny stocks are particularly vulnerable to being stopped out because of their volatility.

Here are some actions you can take to minimize the risk of being stopped out:

  • Set stop-losses on shares with higher trading volume. Penny stocks with greater trading volume generally experience less price volatility. When the stock starts to fall, many investors on the sidelines may purchase at the lower prices and drive shares higher.

  • Use stop-losses on penny stocks with a history of lower volatility. The more volatile a penny stock already is, the more volatile it will probably be going forward. Less volatility means less chance of getting stopped out on price swings.

  • Set stops for greater price declines. Rather than setting your stop only 5 or 10 percent below your purchase price, consider dropping it to as much as 25 percent below your original buy. Although this lower stop puts you at risk for more downside, it also minimizes your risk of getting stopped out if shares fall temporarily.

  • Buy shares on price dips. If you wait to buy shares after a price dip, they’re more likely to have upside in the short term and less likely to fall much farther. The more often you buy penny stocks on price dips, the less likely you will be stopped out.

  • Use trailing stops, either mentally of through your broker. Trailing stops refer to adjusting your stop-loss trigger price higher as the underlying shares move upward. For example if you have a stop-loss at 45¢ on shares that are approaching $1.20, you may want to adjust the stop price up toward $1.

    If the underlying penny stocks then increase to $1.65, you can increase your stop level to $1.35. As the price rises, trail it higher to lock in your profits, and sell as soon as the shares drop back to your trigger price.