Cutoff Point

What Is a Cutoff Point?

The cutoff point is the point at which an investor decides whether or not a particular security is worth purchasing. The cutoff point is very subjective and will be based on the personal characteristics of the individual investor. Some examples of personal characteristics that may determine the cutoff point include the investor's required rate of return and their risk aversion level.

Understanding a Cutoff Point

Because cutoff points are largely subjective, they will vary widely among investors. For example, if an investor has a lower required rate of return, they will likely pay more for the same security than a person with a higher required rate of return. This translates into a higher cutoff point for the first investor.

A cutoff point may also be considered a good "rule of thumb" when considering particular securities, as it may help the investor make more consistent investment decisions. Understanding and setting their personal cutoff points when purchasing securities can help investors protect their profits or limit their losses if the price of the security falls.

Cutoff Points and Stop-Loss Orders

Cutoff points are often acted on by an investor by using 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 cutoff point. An investor places a stop-loss order on a trade before they enter into it. If the stock declines past this cutoff point, a stop-loss order instructs the investor's broker to sell immediately. By using a stop-loss, an investor can limit their losses and be more disciplined in their trading methodology.

If an investor continues holding a stock on its way down without implementing a stop-loss to enforce the cutoff point, the value could continue to fall, and the pain could be severe for that investor.

While investors typically use stop-losses to protect a long position, they can also use them to protect a short position in the event the security gets bought if it trades above a defined price.

Types of Stop-Loss Orders

The percentage an investor sets as their stop-loss is their effective cutoff 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 stock. For example, an investor may purchase a stock and place a stop-loss at 15% below the purchase price. If the stock price falls 15%, the stop-loss will trigger and the stock will sell as a market order.

A trailing stop-loss, by contrast, is established against the previous day's closing price. The trailing stop can be expressed as a percentage of the stock's current price. Because trailing stops automatically adjust to the current market price of a stock, 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 at 15% to 20%. Any less would cause a stock to be sold on temporary dips. If trading on smaller, more volatile stocks, a stop-loss is suggested to be set at 30% to 40%.

Some traders will set two trailing stop-losses. If the stock hits the lower percentage stop-loss, it could be a warning, and a stop-loss could perhaps be set to sell half a position. At the higher percentage stop-loss, such a strategy would liquidate the entire position.