Definition of the cut-off point

What is a cut point?

The cut-off point is the point at which an investor decides whether a particular security is worth buying. The cut-off point is highly subjective and will be based on the personal characteristics of the individual investor. Some examples of personal characteristics that can determine the cut-off point include the investor’s required rate of return and their level of risk aversion.

Key takeaways

  • A cut-off point is a subjective point at which an investor decides whether a security is worth buying or not.
  • Cutoff points vary widely between investors and may depend on the investor’s level of risk aversion or the desired rate of return.
  • By setting a cut-off point, an investor can protect his profits or limit his losses if the price of a security falls.
  • Setting a stop-loss order is a common way for investors to set a cut-off point when investing in stocks.

Understand a cut-off point

Since cut points are largely subjective, they will vary widely between investors. For example, if an investor has a lower required rate of return, they will likely pay more for the same value than someone with a higher required rate of return. This translates into a higher cut-off point for the first investor.

A cut-off point can also be considered a good “rule of thumb” when considering particular securities, as it can help the investor make more consistent investment decisions. Understanding and setting your personal cutoff points when buying securities can help investors protect their gains or limit their losses if the security’s price falls.

Cut points and stop-loss orders

Investors usually act on the cut-off points by means of a stop-loss order. Unless a trader or investor has extraordinary discipline, using a stop loss is the easiest way to act on a strict cut-off point. An investor places a stop-loss order on a trade before placing it. If the stock falls beyond this cutoff point, a stop loss order instructs the investor’s broker to sell immediately. By using a stop loss, an investor can limit his losses and be more disciplined in his trading methodology.

If an investor continues to hold a falling stock without implementing a stop loss to enforce the cut-off point, the value could continue to fall and the pain could be severe for that investor.

While investors often use stop loss to protect a long position, they can also use it to protect a short position in the event that the security is bought if it trades above a set price.

Types of stop-loss orders

The percentage that an investor sets as his loss limit is his effective cut-off point. There is more than one type of stop-loss order. A standard stop loss is set as a percentage below the price paid for the shares. For example, an investor can buy a share and place a loss limit 15% below the purchase price. If the share price falls 15%, the stop loss will be triggered and the shares will be sold as a market order.

Rather, a trailing stop loss is set against the closing price of the previous day. The trailing stop can be expressed as a percentage of the current share price. Because trailing stops are automatically adjusted to a stock’s current market price, they provide the investor with a way to lock in gains or limit a loss.

Special Considerations

Investing experts suggest setting a stop loss percentage of 15% to 20%. Any less amount would cause a stock to sell in temporary dips. If you trade smaller and more volatile stocks, it is suggested to set a stop loss between 30% and 40%.

Some traders will set two stop loss limits. If the stock reaches the lowest percentage stop loss, it could be a warning, and perhaps a stop-loss could be set to sell half a position. At the highest stop loss percentage, such a strategy would liquidate the entire position.

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Mark Holland

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