Protecting Gains With A Stop-Loss

I’d venture to say that given the current market euphoria, a lot of you probably are sitting on some hefty paper profits right now. But anybody who has invested in the past has no-doubt said to him or herself, "if only I sold when I was ahead."

Alert readers and listeners to my radio show already know the answer: You can accomplish your wealth-building goals and still avoid downside risk.

How do we do it? Well, we use stop-losses on all of our stock positions.

What is a stop-loss? Simply put, it is a pre-set percentage that one is willing to give back on unrealized gains. For instance, if you have a 12% stop-loss, you will sell your fund when it drops 12% from the highest point it reaches from the date of purchase.

Here’s a real-life example. One radio listener, we’ll call him Gary, allocated 33% of his portfolio to an ETF sector during June 2000. He used a 10% stop-loss on the position. The ETF moved approximately 30% higher, and then fell 10% in mid-October.

Gary was stopped out. He was able to lock up a 20% gain, protect his assets, and begin preparing for new opportunities. Most importantly, he learned just how volatile his sector fund could be. Not surprisingly, if he had held just two more weeks, he would have given back another 15%, or nearly all of his earnings.

How do you set a stop-loss? Before you buy, you make a decision on how much you realistically could stomach losing. I’m not just talking about giving back money — I’m talking about losing it. If you put $10,000 into a stock fund today, how much could you stand to give up — $1,000 (10%), $1,500 (15%) or $2,000 (20%)?

Starting from the date of your purchase, you will use this percentage of the stop-loss as the amount that you’re willing to sacrifice before you sell the position. At first, you will be protecting your principal. But as your fund heads for higher ground, you will move this stop-loss up with the price movement of your investment; that is, if you have a 12% stop-loss, you will sell your fund when it drops 12% from the highest point it reaches from the date you first invested.

Example: You buy fund X at $50. Fund X moves to $75 over the next several months for a 50% unrealized gain. Then it hits a broad market sell-off and drops to $66. That’s a 12% drawdown, so your stop-loss has been hit and you sell the fund. But you pick up a healthy 32% gain!

Perhaps the most frequent question I receive about stop-losses is, "When do I buy it back, Doug?" This question presupposes you will pick the exact same stock, fund or ETF, which you may not. The beauty of selling is that you are able to reevaluate all of your choices and then pick a new position with the greatest potential upside.

Stop-losses have plenty of side effects. You’re going to give up money. And there will be times when you lose outright. But it is a safety net strategy that smart investors faithfully employ — avoiding the tragedy associated with excessive downward pressure and volatility.

One of the best protection mechanisms out there is a stop-loss, but knowing how much you are willing to risk and monitoring your holdings so as not to miss any stop-loss points is essential to sound portfolio management.

It’s this kind of sound management you’ll get when you subscribe to my Successful Investing advisory service. Successful Investing subscribers know they will be protected when the next inevitable market sell-off begins. Learn how you to can protect yourself from the ravages of a potentially sharp market correction that could eat away at your nest egg. All you have to do is click here.

To find out how to get started with Successful Investing, click here.