Use Stop Loss Orders to Protect Your Gains

"The best defense is a good offense." Though the adage may be overused these days, it holds that the surest way to victory is often achieved through action ― not just by waiting for your enemy to attack. The same is true of investing.

As I write this, we're sitting at the top of a historic rally; since the market found its most recent low in March, the S&P 500 index is up nearly 34%. And more and more cautious investors are becoming nervous. After all, how much higher can the market go in such a short time period?

That building sense of investor queasiness could turn into a self-fulfilling prophecy when all of these jumpy top stocks buyers become sellers at the first sign of a pullback. Just take a look at the chart below.

We may be just 4-5% away from the next technical stumbling block traders are watching out for ― the 200-day moving average of the S&P 500.

As the S&P climbs nearer to the red line, you can expect technical analysts to watch intently. Trading off these movements is their bread and butter. What that means for fundamentals guys is that we should be watching our portfolios very carefully right now.

But there is one very good way to protect your gains right now ― it's called a stop loss.

Basically, a stop loss (or stop, or stop order, etc) is an order with your broker to sell your shares in a particular top stocks 2010 automatically when its price hits a specific level. That means if your shares of Stock A are up 30%, you can set a stop loss to trigger when the stock drops to 25%, guaranteeing your minimum profit.

While there are several different types of stop losses, these three flavors are worth knowing about:

Stop Order: Triggers once your top stocks reaches a specific target price, the stop price.

Trailing Stop: Triggers at a specific change in price, measured by either percentage points or dollar value.

Stop Limit Order: Similar to the stop order, except for the fact that a limit order is triggered once your top stocks reaches a specific target price. (i.e. sell high, and re-buy low)

Clearly, the biggest benefit of placing stop losses is the fact that you won't have to lose sleep over your open positions ― if the top stocks for 2010 you own take a big dive, your positions will sell off before any major damage is done. That's a pretty compelling case for using stops. Still, that's not the whole story…

Drawbacks of Stop Losses

The biggest reason that people lose out on stop losses is through short-term fluctuations in stock price. If you have a stop set at 5% below a stock's current price level, and the stock swings 10% in the week, your stop will trigger and you'll miss out on the stock's rebound. As a result setting your stop losses intelligently is essential.

But exactly where to place your stop-losses is another tricky bit of business. It takes even the most skilled traders a good bit of trial and error to learn what works when it comes to setting stop losses.

If you're a believer in fundamentals, it's best to think of stop losses as profit keepers. You should place them at the level of gains you're comfortable walking away with. If one of your positions is up 20%, 15% gains may be the least you're willing walk away with ― if that's the case, it makes sense to put your stop losses there.

Even if you're a fundamental investor, stop losses can be most valuable when they're combined with technical analysis (using chart patterns to determine where a stock's price is going). After all, technicals are what drag fundamentally sound companies down during a bear market. Unlike with fundamentals, where stop losses can be considered "profit keepers" you can think of technical stop losses as insurance ― a way to ensure that your top stocks won't go into freefall.

Stops can be very useful when they're placed under a stock's support level (the price level that a stock has trouble falling below). That's because to a trader, a price level below support generally means that the top stocks could be breaking out much lower.

Don't Stop the Stops

Whatever your investing strategy, stop losses can be a valuable part of your investing toolbox. That said, using stop losses and other more complex broker orders can be tricky for beginners ― always make sure you understand what you're doing before you commit money to a trade. Here at the Penny Sleuth, we'll keep doing our best to provide you with an investing education.