Should I use stop-loss orders?

Many people swear by them as a way to lock in gains and minimize losses, others refer to them derisively as “stop-gain” or “guaranteed-loss” orders. So, should you use stop-loss orders when buying stocks?

How do stop-loss orders work?

When you place a stop-loss order, you’re telling your broker to sell a stock once it hits a specific price, typically 10% below your purchase price. If you buy a stock at $30 and enter a 10% stop-loss order, your order will convert into a market order if the stock trades below $27. The theory is that in the event of a huge drop, you’ll be largely protected, without having to lift a finger.

Sounds pretty great, right?

If you’re on vacation or somewhere where you won’t be able to manage your brokerage account for a long time, it could make sense. Or if you’re a trader who is bopping in and out of investments throughout the day — not an approach we recommend — it could save you time and money.

But if you’ve got a long-term view and an Internet connection and you’re not trapped under a very heavy rock, stop-loss orders could do your portfolio far more harm than good.

The big downside of stop-loss orders

At The Motley Fool, we encourage long-term investing — buying solid, high-quality companies and holding them for the long haul. That means riding out short-term gyrations: a stumble on a product launch, an ugly rumor circulating on social media, an analyst dropping his guidance from buy to hold.

The fact is that 10% losses are far from rare, and often are mere blips on the way to far greater gains.

“If you have bought stock in a company that you believe in, shouldn’t you give that company time to perform to your expectations,” asked Motley Fool member Paul Thomas. “Stocks over the course of a year usually gain or lose 10% at least once or twice in a year, and most stop-loss orders are set at a 10% loss point. You are practically guaranteeing that you will sell the stock at a loss.”

As markets fluctuate, prices of stocks can drop quickly and they can recover nearly as fast. If the stop-loss order is triggered, the price will often bounce to a higher level than the stock was sold at. If you try to buy the stock again, it’ll be at a higher price … and as an added bummer, you’ll be stuck paying two commissions.

Some other considerations

Additionally, in a taxable account, there might be tax consequences to consider. If the sale is at a loss, the loss will be disallowed if the stock is repurchased too quickly (thanks to the Wash Sale Rule).

Finally, when you enter a stop-loss order, you’re not specifying the minimum price you’re willing to get for your shares — the only limiting factor on that market order is that the stock has to trade below the stop-loss point.

“If you buy a stock at $35 and would only want to hold that stock as long as it trades above $30, you’d set a stop-loss order,” said Fool member Michael Sandrik. “But the stock could trade down to $25 before your shares can be sold due to a rapid plunge in price or, if it’s a less liquid name, inability to find a buyer right away. The market order doesn’t care about these things and your shares will be sold anyway…. You might end up selling out of the stock at a much lower price than you ever intended with a stop-loss order.”

Alternative approaches

If this method of setting automatic gates to sell at a certain price appeals to you, explore stop-limit orders. They’re similar to stop-loss orders except that they use a (you guessed it) limit order for the transaction instead of a market order. This way, you know that you won’t end up selling at a price beneath what you’re comfortable with. Sure, this won’t help you out if the stock rapidly falls from $35 to $10 and never recovers, but it’ll keep you from being dumped out of a stock on a volatile day right at the stock’s low point.

Another alternative is activating price alerts for the stocks you buy so that you’ll be notified via text message or email whenever a stock’s price rises or falls from the current price. (To start, try setting it at plus or minus 10% change). This option lets you research what caused that gain or loss and then decide for yourself whether or not to sell.

We know that volatility can be scary – in fact, our investing services such as our flagship Stock Advisor come with a 10% Promise of coverage on recommended stocks that rise or fall 10% in a day. But we feel you should look to the long term and make informed decisions to buy and sell rather than have those decisions happen to you.

“Instead of using these order, know the reasons to sell an investment. Sell for those reasons, not because the price dropped,” said Motley Fool member Gene Dettmann. “A good business with quality management will recover from a price drop and will continue to grow. Prices will fluctuate. Price drops for these types of investments are opportunities to buy, not reasons to sell.”

If you’re interested in finding a bunch of great stocks and ongoing coverage of them, click the link for a free 7-day trial to Stock Advisor.

— Answer provided by Fool members Gene Dettmann, Michael Sandrik, and Paul Thomas, and intern Caroline Jennings

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