—Field of Dreams

Volatility may be a trader's best friend, but for the average investor these days, it is more like the guest that wouldn't leave. After a few nights on the sofa, the wild twist and turns have made themselves quite at home.

That has left more than a few retail investors wondering exactly where the next pitch will be.  

And for all of them, guessing correctly will mean the difference between the thrill of victory and the agony of one in the earhole. Or in this case, either sadness or euphoria.

One, of course, is much more preferable than the other.

Needless to say, that makes for a pretty tough investing environment — especially when you just can't decide whether it is green shoots or the ghost of Tom Joad.

However, that doesn't mean for a second that investors ought to simply roll the dice in these markets and hope for the best.  That's not exactly a winning strategy.

Instead, what every investor should be doing is using a combination of Stop/Loss Orders to protect their portfolios from the inevitable wild pitch, since failure to do so could cost them dearly.

Here's how stop/loss orders work.  

Taking the Mystery Out of Stop Loss Orders

Simply put, a stop/loss order is what stands between your portfolio and the danger of losses that are simply too big to face — kind of like an insurance policy you hope you'll never need.

Also known as a "stop order" or "stop-market order," it's an order placed with your broker to sell a security once the stock has hit a certain price. And once your predetermined stop level has been reached, your order goes "live," and the shares you hold are liquidated.   

No fuss. . . no muss.

For example, let's say you just loved the Kindle and established a position in Amazon stock (AMZN) for $80.00 a share. To protect yourself against a wicked downdraft in that position or in the broader markets, you would simply follow up that buy with a stop/loss order you could live with if the markets suddenly turned against you.

For instance, if a 10% loss is all you can handle then your stop/loss order in this case would be set to execute once the price reached $72.00. That would save you the agony of much steeper losses if the sell off were to continue. Moreover, it eliminates the emotions that often turn investors into "trapped longs," which is something that can take years to recover from.

And if you don't believe me, just ask those "buy and hold forever" types how they're riding out the current downturn. The odds are they wish they got stopped out a year ago.

That being said, there are two types of stop/loss orders, and it is important to know the difference.

One is a stop market order, which automatically sells the allotted shares at "the market" once the order is activated. In short, it is the equivalent of a market order, meaning your shares will be sold at the bid until they have all been sold. The price you sell your shares for can sometimes fall below your stop price, especially in fast-moving markets or thinly traded stocks.

The other type is a stop limit order, which also activates a preset level. However, in this case the order combines the features of a stop order with those of a limit order. As such, once activated, your shares will be liquidated at limit price or better. The downside, of course, is that if the stock keeps falling then your limit will not be reached, exposing you to further losses.

Lock in Your Profits with Trailing Stops

However, as important as stop/loss orders are, preventing big losses isn't the only way to use them. That's because savvy traders also use them on occasion to "lock in profits," once again taking the emotion out of the trade.

Doing so, they employ what is known as a trailing stop.

Here, the stop-loss order is set at a percentage level below the current market price — not the price at which you bought it originally. As such, the price of the stop/loss actually adjusts as the stock price fluctuates from day to day. It is used in cases when the share price has turned green, ensuring gains during a pullback or a deeper correction.

The bonus is that using a trailing stop allows you to "let profits run" while at the same time guaranteeing at least some realized capital gain. 

Continuing with our Amazon example from above, say you set a trailing stop order for 10% below the current price. Meanwhile, the Kindle turned out to be the game-changer you thought it would be, and shares of Amazon were hitting $150.

Your trailing stop order would then lock in at $135 per share ($150 - (10% x $150) = $135). This is the worst price you would receive, so even if the stock takes an unexpected dip, your profits of $55/share would be "locked-in." (On an $80.00 original purchase)

Of course, keep in mind the stop/loss order is still a market order, so the price of your sale may be slightly different than the specified trigger price.

Steve Christ, Investment Director

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