In a recent article ("A Market Crash Is Coming"), I advised readers who were worried about market crashes to consider using stop-loss orders, which they can place with their brokerages. I said:
If you're frightened of any kind of significant drop, you might want to place stop-loss orders for your holdings with your broker. ... You can, for example, specify that if Stock ABC falls 10%, you want it sold ASAP. This can protect you, but it can also evict you from some great performers that temporarily slump.
I stand by what I said -- stop-loss orders can be helpful in such situations. But not always.
For example, sometimes the market can fall so quickly a stop-loss order might get you out of a security at a lower price than you wanted. This can happen during earnings season. Since most of the earnings announcements come either before or after market hours, stocks can go up or down significantly and go past the stop-loss order. An average investor during this time is at a huge disadvantage because he or she cannot easily trade during non-market hours.
Sometimes the very existence of too many stop-loss orders can make a bad market day worse. As Jeremy J. Siegel, professor of finance at Wharton, has explained, "The truth is that many market movements are not due to economic forces but to traders watching what other traders are doing."
He has described one bad day in the market this way:
Trend-followers knew that the bull market wouldn't last forever. They protect their profits by placing stop-loss orders below the current price. A stop-loss order tells the market maker to sell whenever the stock penetrates a predetermined level. Because the market [hadn't fallen by as much as 2%] for so long, many stop-loss orders were placed 2% below the market. Once the 2% limit was breached, a wave of selling broke out.
Voila -- that's sometimes all it takes to start a chain reaction of selling. It isn't that investors are necessarily pessimistic about the market -- it could be that sell orders are being placed automatically, resulting in more sell orders. And once the dust finally settles, the market typically begins rising again -- with the sellers sitting on the sidelines.
The bottom line is that there are pluses and minuses to stop-loss orders, as there are with other broker orders. Learn about limit versus market orders in this article, which explains how the volatility of stocks such as Apple
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Longtime Fool contributor Selena Maranjian does not own shares of any company mentioned in this article. Try any of our investing services free for 30 days. The Motley Fool is Fools writing for Fools.