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 (NYSE:TSO) and AMD (NYSE:AMD), have slowly but surely seen a big portion of their value slip away, a technique that could limit your losses looks appealing. But while using stop-losses does provide some protection against major hits to your stock positions, the strategy also has its weaknesses.

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 (NASDAQ:GOOG) closed around $530 last Thursday, immediately before announcing earnings. You might have decided to set a stop-loss order at $520, hoping to limit your losses in the event of a bad report. However, when the market opened the next morning, Google first traded under $500. As a result, if you used a market order with your stop-loss, you wouldn't have gotten $520 for your shares -- you would have gotten less than $500 instead. The stop-loss wouldn't have limited your losses as much as you wanted.

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 (NYSE:HAL) might recover from temporary setbacks and turn into a five-bagger, there are also plenty of stocks still seeing huge challenges for their businesses. Getting out early could have saved you thousands:


Share Price If Sold After 25% Trailing Stop-Loss

Current Share Price If Held

General Motors (NYSE:GM)



Fannie Mae (NYSE:FNM)



Washington Mutual (NYSE:WM)



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.

Further Foolish advice: