When you invest during a bear market, risk will always be on your mind. While you may hope to take advantage of beaten-down share prices to grab stocks that will turn into multibaggers, it's just as important for your overall returns to avoid taking a big loss on any one position, should things not go as you expect.
To prevent small losses from becoming big ones, many traders use stop-loss orders. In a market where many companies, such as Tesoro
The basics of stop-loss orders
The way stop-losses work is pretty simple. For a given stock, you decide the maximum amount you're willing to lose. You then calculate how low your shares would have to go to create a loss that big. By entering a stop-loss at that level, if the share price ever falls below it, your shares will get sold, thereby preventing any further losses.
Most brokers allow you to enter stop-loss orders for your account. You can choose any price for your stop-loss that you want, as long as it's below the current trading price. If all goes well, and your stocks move upward without ever hitting your stop-loss price, your orders will never execute, and you'll enjoy the full benefit of seeing your shares skyrocket.
You can use stop-loss orders in various ways. Some investors set stop-losses immediately after they buy a stock, then leave them alone. Others use trailing stop-losses, where they raise the trigger price on the stop loss as the stock goes up. For instance, if you bought shares of a stock at $50, you might set an initial stop at $40. Once they rise to $100, though, you could move the stop-loss up to $80, in the hopes of locking in at least a $30 profit.
Nothing's perfect
Unfortunately, stop-loss orders don't always work the way investors want them to. For one thing, share prices sometimes fall dramatically, especially when companies announce bad news while the market's closed. As a result, you may not be able to get the price you wanted if a stock's drop triggers your stop-loss order.
For instance, Google
The long-term dilemma
Although losses from sharp stock plunges can make stop-losses ineffective, these orders have an even bigger shortcoming as well. If you think a stock is an attractive investment over the long run, stop-losses can take you out of your position at exactly the wrong time -- just as they hit bottom and resume their long-term uptrends.
The real question is whether stocks are dropping because of actual fundamental problems with their underlying businesses. While a company like Halliburton
|
Stock |
Share Price If Sold After 25% Trailing Stop-Loss |
Current Share Price If Held |
|---|---|---|
|
General Motors |
32.40 |
13.09 |
|
Fannie Mae |
52.93 |
14.13 |
|
Washington Mutual |
35.26 |
5.48 |
Source: Yahoo! Finance. Assumes initial buy date of Jan. 1, 2006.
Should you use stop-losses?
Unfortunately, it's hard to know up front whether you're seeing a temporary blip or the beginning of a much larger plunge. In the end, deciding to use stop-losses depends on your risk tolerance. If avoiding the next Bear Stearns is worth occasionally missing out on what later becomes a rocket stock, then stop-losses are worth considering. But if you're willing to risk losing everything on one stock in exchange for huge rewards on others, you'll probably find stop-losses more frustrating than they're worth.
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Fool contributor Dan Caplinger does everything he can to stop losses in their tracks. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy makes you a winner.
