Charles Rotblut, CFA, a vice president at the American Association of Individual Investors (AAII) and editor of the AAII Journal, Chicago. AAII.com
One of the most effective strategies to minimize losses on a falling stock or to avoid having all your profits vanish can backfire in very volatile markets. The strategy—placing a “stop-loss order”—allows you to automatically sell shares of a stock or an exchange-traded fund as soon as they drop below a predetermined price. For a blue-chip stock, investors typically set the order to be triggered 10% below the price they paid. For more volatile stocks, 20% is typical. That way, the order does not trigger a sale every time the market has short-term swings.
The problem: If a market downturn is especially sharp, the price may suddenly drop way past the trigger price that you set. You may end up selling the shares at a much lower price than you imagined. And to make it worse, the stock’s price may quickly recover after you have sold. That’s what happened for many investors in August, when the Dow Jones Industrial Average fell more than 1,000 points soon after the opening bell before bouncing back…and some blue chips, including General Electric and PepsiCo, plummeted more than 20% but quickly recovered.
What to do: Add a “limit” to your stop-loss order, which means that the stock won’t be sold for a price lower than what you specified. You also can set up a “price alert,” which works best in down markets where the decline is more gradual, over periods of days or weeks. Alerts notify you by e-mail or text when a specific price is reached. Example: If your stop-loss order is set 20% below your purchase price, you can get a price alert after a 10% pullback. This gives you time to analyze why the stock is falling and determine whether you want to keep your stop-loss order in place.