As stock markets have pulled back from their recent highs, you may have wondered about using stop-loss orders to protect your profits.

However, before you try this approach, you should keep in mind that stop-loss orders have a number of risks that can cost you money. Read on and we’ll take you inside this investing strategy, and point out some of the dangers that stop-loss orders can expose you to.

We also give you some simple, easy-to-implement stock trading advice that offers a far better way of protecting—and growing—your profits.

Stock trading advice: How stop-loss orders work

Stop-loss orders are a direction to your broker to buy or sell a stock if it hits 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.

Here are three ways stop-loss orders can hurt your returns:

• You could be forced to sell your best picks way too early. If a stock is going to rise from, say, $20 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.
  
  You can add a price limit to your stop loss, but that just nullifies the stop so long as the price is below the limit.

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• You may not even get your stop price. 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.
• Here’s a situation where stop-loss orders could be helpful: 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. But few speculatives ever reach that degree of investment quality.

Our stock trading advice: Instead of stop-loss orders, we think you would be far better off sticking with our three-part TSI Network stock trading advice 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.

You can get our latest advice, including our in-depth analysis and clear buy/sell/hold advice on dozens of Canadian stocks when you take a no-risk 1-month FREE trial to The Successful Investor today.

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