Topic: How To Invest

Stop-loss orders: A stock trading strategy with hidden pitfalls

Stop-loss orders are a stock trading strategy investors use to sell a stock if it falls to a specific price.

For example, if you own a $12 stock, you might tell your broker to sell it “on stop” if it hits $10. This may limit your losses if you paid more than $10. If you paid less, it may preserve some of your profits.

Stop-loss orders: A good stock trading strategy for filtering your profits

The main problem with this stock trading strategy is that it forces investors out of their best stock picks too early. After all, if a stock is going to rise from, say, $10 to $100, it will go through many short-term downturns along the way. Some may be $2, some $10, $20 or even more. Investors may avoid some losses with stop-loss orders, but they’ll always sell the strong performers when they are just getting started.

Limit orders and trailing stops don’t fix the main flaw of stop-loss orders

To avoid selling too low, you could put a limit on your sell order (if your broker will accept one). For example, you could “sell on stop at $10, limit $8.” But this is at odds with the purpose of the stop-loss order, which is to help you get out of the stock if it starts to plunge.

With a “trailing stop,” investors raise the price on the stop-loss order with each rise in the price of the stock. For instance, they can continually raise the price on their stop so that it is always $2 below the latest high on the stock. This means their stop-loss order will go into effect the first time the stock has a $2 setback from a recent peak. But here too, if one of your best performers has a setback of more than $2, you’ll have sold it before it begins its next move up.

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Stop-loss orders sometimes don’t even work

The triggering of the $10 stop-loss order doesn’t automatically mean that you will sell the stock for $10. Instead, you put in a “sell-at-market order.” However, if other investors don’t bid anywhere near $10, you could lock in a sale at a much lower price. That’s particularly true if the stock is falling sharply.

As well, if other holders put in stops at $10, and many sell-at-market orders hit the market at the same time, everyone may wind up selling for far below $10.

Our three-part stock trading strategy is a better long-term approach than stop-loss orders

As a general rule, it’s best to avoid using stop-loss orders, especially on any sort of habitual basis. On the whole, all they do is generate extra trading and the extra commission expense that goes with it.

Instead, we think you would be far better off sticking with our three-part program of investing in well-established companies, spreading your money out across the five main economic sectors and focusing on stocks that seem to offer value that is hidden or underappreciated.

This system requires more attention and effort than stop-loss orders. But it will serve you much better in the long run.

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