Investing Basics: How to Protect Yourself With Stop-Loss Orders

It might be the least satisfying and most frightening moment in trading: That split second before you hit the "sell" button.

If a stock is up, there's always that nagging feeling that you might be missing out on more gains. The hardest decision comes if the trade goes the other way. If you're down, selling means admitting you made a bad call and now you're poorer because of it. All that heightened emotion (and the accompanying numbing affect on many investors' judgment) makes saying goodbye to a misplaced bet both one of the most difficult of all investment decisions, and one of the best arguments for having a rock-solid exit strategy already in place.

That's because one of the dirty little secrets of investing is that almost everyone is terrible at losing, says Chuck LeBeau, director of quantitative analytics at SmartStops.net. "People don't like to sell stocks at losses. That's very well known in academic circles; it's called the 'disposition effect.' Investors are 72 percent more likely to sell a stock if it has a profit than if it has a loss," he says. "We're brought up with a win-win mentality ... if they sell a stock at a loss, there's this feeling that they've failed. It's a psychological hurdle that needs to be overcome because from a result standpoint, it's what they need to do. If they can control losses, they'll actually make more money."

The problem is that most investors have no such plan in place to limit their downside risk. And who can blame them? Commonplace buy-and-hold wisdom repeatedly tells us that market gains come mostly from just a handful of stellar trading days, so you'd better be in when the market is up. That's true. The same, however, is true on the downside. When markets drop, getting out might be even more important.

LeBeau conducted 10-year study of the S&P 500, which showed that in all instances where the market experienced a 15 percent drawdown, more than half of the stocks in the index had declines of at least 60 percent peak-to-trough. The lesson? There's a good chance for a big fall in a high percentage of stocks. (Also, the study ended in May 2008, so it didn't include the starkest illustration of that possibility in recent memory—the huge drop at the end of 2008.)

What's worse, the long-term damage from a huge drop can often be more crippling than missing the run to the upside. Remember: To recover from a 60 percent loss on a stock, investors must see a gain of 150 percent from the low. It barely needs mentioning that such gains rarely happen quickly (or at least not anywhere as quickly as the drop occurred).

Still, Chris Larkin, senior vice president of E-Trade Securities, says "very few" of his customers take steps to limit their risk. Luckily, the tools to keep losses in check are readily available and easy to use.

[See The New Safe Portfolio: Why Stocks, Bonds, and Cash Aren't Enough Anymore.]

Some ways to protect yourself: A stop-loss order is the most basic of safety nets. It's simply an order to sell when a share's price falls a certain percentage. Trailing stop orders, which can be set to track a stock's price as it rises and are triggered only when shares fall either a dollar value or a pre-set percentage below the market price, offer protection even as shares climb.

Rules of thumb vary for setting stop losses, depending on your risk tolerance and the state of the market. Estimates range from the conservative (say 8 percent) to as high as 25 percent on volatile stocks. Many analysts recommend tighter stops because while a single-digit loss might hurt you pride, it won't decimate your portfolio and you'll live to invest another day.

Setting a stop-loss order can be done on a daily basis or it can be extended over several months, depending on your broker (E-Trade, for example, limits stop orders at 60 days.)

The downside, of course, is the unfortunate circumstance where an investor sets a stop, sells when the price falls below his stop, and then watches the stock bounce right back and keep on climbing. Getting "stopped out" is among the more frustrating moments for traders, and it's the biggest argument against using stops, especially during extremely volatile markets like the one we've seen over the past year. There are ways around that as well.

[See Emergency Money: 5 Steps to Survive the Financial Crisis If the Unexpected Strikes.]

Most online brokers offer a system of alerts you can use in place of actual stop-loss orders. It means keeping an extra eye on your account, but using e-mail triggers rather than actual stop-loss orders can keep you from selling during a fluke (for example, when a single bad day in the market sends your stock down hard). You'll also avoid transaction costs since E-mail alerts are free, unlike broker fees. Plus, with E-mail alerts, you can place stop-loss orders in a tighter range since there's not the same risk of being "whipsawed" out of a trade, writes investment author Leland Hevner.

Online alert services also offer easier ways to set and monitor stops, and they push the strategy a step further by taking into account a stock's individual volatility with an eye toward swings happening in the wider market. LeBeau's SmartStops.net uses quantitative models based on stock history and overall market volatility to suggest short- and long-term sell points. Investors can get advice on three stocks for free, or a whole portfolio for a monthly fee.

Keep in mind, however, that using alerts instead of strict sell orders opens investors up to their emotions. ("They'll use the 'mental' stop order and they'll start changing their mindset," Larkin says. "You want to make sure they take that emotion out of trading.")

Still, just learning how to use stops is worth the time since it gets investors asking the right questions, Larkin says, including "How much money are you willing to lose on this particular trade?"

"That generally gets people somewhat uncomfortable because they aren't thinking in those terms. They're thinking very positively," he says. "It might take a little time to understand how to use them, but it's time very well spent in the end."

For more on stop-loss and other conditional orders, see this handy tutorial from ETrade. And for advice on how to set stops, see ETrade's "The Science of Setting Stops" webinar.