On Thursday, May 6, 2010, the Dow Jones Industrial Average opened at around 10,860. Later that afternoon, it suddenly fell 9.2%, to 9,869.62. In the space of just a few minutes, it had recovered most of these losses, and closed at 10,520.32. It’s now back to its pre-crash level of around 10,860.

The Securities and Exchange Commission (SEC) is investigating the drop, but an exact cause has not yet been found.

No matter what caused the crash, some of the trades that occurred between 2:40 p.m. and 3:00 p.m. eastern time have already been cancelled. The New York and Nasdaq exchanges have cancelled all trades that occurred during that window that were more than 60% higher or lower than the stock’s price just before the plunge.

Investors whose trades are not cancelled and whose stock market trading strategy involved the use of stop-loss orders could be among the biggest losers.

Stock market trading strategy: How stop-loss orders work

Stop-loss orders are a direction to your broker 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.

However, the triggering of a stop-loss order doesn’t automatically mean you will sell the stock at $10. Instead, your stop-loss order becomes a “sell-at-market order.” But if other investors don’t bid anywhere near $10, you could lock in a sale at a much lower price. You can put a limit on a stop-loss order, but that defeats your purpose in a swift market decline.

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May 6, 2010: A “perfect storm” for stop-loss investors

The May 6 market decline provides a good example. Let’s say you held Procter & Gamble (symbol PG on New York), one of the stocks we cover in our Wall Street Stock Forecaster newsletter, and had told your broker to sell it “on stop” if it fell below $50. (Before the drop, Procter was trading at around $63.)

At the height of the crash, Procter had fallen to $39.97, for a 37% drop. That’s what you may have sold your Procter shares for if you had a stop-loss order on the stock. What’s more, now that Procter has rebounded back to around $63, you wouldn’t have enough cash from the sale to buy back your holdings.

To top it off, if you originally bought Procter for less than $39.67, you would have to pay capital gains tax on your profits.

Stop-loss orders: A stock market trading strategy that may force you to sell too early — even in less volatile markets

Even without the extreme market conditions of May 6, 2010, stop-loss orders can force investors out of their best stock picks too early. After all, if a stock is going to rise from, say, $10 to $100, there’s a strong possibility that 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 increase the likelihood that they will sell their strong performers when they’re just getting started.

Stop-loss orders may be useful for speculative stocks

At times, mechanical investing aids like stops can work. But most investors who rely on them wind up losing money in the long run. That’s why we’ve long recommended that investors avoid using stop-loss orders, especially on any sort of habitual basis.

However, with speculative stocks, it’s better to use a stop-loss order than to buy and forget it. You can get away with the “buy-and-forget-it” approach for a time, if you buy high-quality stocks like those we recommend in The Successful Investor. But few speculatives ever reach that degree of investment quality.

That’s why 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 avoiding stocks in the broker/public-relations limelight.

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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