Will You Sell Out Before Your Stocks Collapse?

With the Dow finally topping the 10,000 mark yesterday for the first time in a year, lots of bullish investors are hoping that the party's just getting started. If you're more concerned that shareholders are getting too greedy for their own good, however, you're probably thinking more about protecting the gains you've already made than trying to eke out more profits from the rally.

Nothing is more painful than seeing all your paper gains on a stock position evaporate when a market downturn comes around. To avoid having to go through that experience, there's a strategy that many investors use to try to sell their shares before a small correction grows into a profit-pummeling drop.

Stopping your losses
Stop-loss orders offer a simple way to protect gains on a profitable position. All you have to do is figure out how much you're willing to see a particular stock drop before you'd conclude that the rally was over. If you then entered a stop-loss order at that price, your shares would be automatically sold if the stock ever traded at or below the price you picked.

You might wonder why you'd want to sell at a lower price if you didn't want to sell at the higher price. The goal of the stop-loss order, though, is to capture as much of a long-term uptrend as you can. If you simply sell your shares, you lock in a sure profit -- but you miss out on any future gains. A stop-loss order, however, lets you make more money in a rising market; if the stock keeps going up, your stop-loss will never get triggered, and you'll add to your gains.

In fact, many brokers allow you to set trailing stop-losses. These special orders automatically boost your stop-loss price as the stock rises, saving you from having to change the order manually.

Mixed results for stop-loss orders?
When stop-loss orders work, they often work brilliantly. For instance, if you had set stop-losses two years ago, toward the end of the bull market in 2007, you would have held onto a lot more of your gains from previous years. Consider these examples:

Source: Yahoo! Finance. Stop-loss price based on closing price on Oct. 15, 2007.

A stop-loss order could have saved you thousands of dollars in losses. And that's after taking into account that these stocks have all made big gains since their lows.

Stop-loss orders are far from perfect, however. The closer you set your stop-loss to the current share price, the more likely it is to get triggered. And if the move that triggers the order turns out to be a brief correction before a big move up, you could end up selling at exactly the wrong time.

For example, if you'd bought stocks last November at their lows, then by early January, you had some pretty strong gains. Setting stop-losses would have saved you from the following drop in February and March, but it also would have taken you out of the ensuing rally. As you can see below, that would have cost you plenty in some cases:

Source: Yahoo! Finance. Stop-loss price based on closing price on Jan. 2, 2009.

It's not that you wouldn't have made a profit. The stop-loss would have worked to lock in good gains for an investment of just a couple months. But it also would have taken you out right before some explosive gains.

Be smart
That's one reason why stop-losses work best for stocks you've already decided to sell. In that case, you're comfortable getting stopped out of your position. In contrast, when you like a stock whose stop-loss gets triggered, you don't know what to do next. If the shares rebound, do you buy them back later at a higher price -- or risk missing an even bigger move up?

Nevertheless, with risk a big concern for many investors, stop-loss orders are worth considering. If you're comfortable with the tradeoffs involved, then they can make it a lot easier to protect yourself from a future market downturn.

Think the rally is just getting started? Read why Matt Koppenheffer thinks that coming earnings reports hold the key to the rally.