Bull, Bear Markets Confound Stop Orders

Investors typically employ stop orders, which are used to buy or sell securities at a specific price, for short-term trading. But they can help manage a diversified investment portfolio.

The first issue is where to set a stop price. Many people place a stop order 8% below the purchase price, though that type of move is common for some stocks.

The following chart compares the 2009 performances of Clorox(CLX Quote) and Citigroup(C Quote). Clorox doesn't move a lot, so using an 8% limit make sense. Citigroup has had ups and downs exceeding 10% on 50 of 83 trading days from the end of the year through May 1. Plenty of other shares behaved the same way in the bear market, which is problematic because almost everything declined dramatically during this period. As a result, your brokerage commissions would have gone through the roof.

Clorox vs. Citigroup Yahoo! Finance

Another potential issue with getting "stopped out" is that your stock, which presumably you liked when you bought it, turns around and rises quickly. An example is Deere(DE Quote). From an intermediate high of $41.81 on Feb. 6, Deere fell 40% in less than a month as investors panicked. Deere climbed above that level less than two months later. Anyone nimble enough to have bought it in the mid-$20s after getting stopped out in the high $30s would have had a fantastic trade. An argument could easily be made for having held on as the stock has more than recovered.

Deere vs. Industrial Peers Yahoo! Finance

The last issue to address is why you bought the stock in the first place. It would make sense to think of a stock as a proxy for a sector or maybe a country or theme. Sticking with Deere as an example, an investor who bought the company shouldn't have presumed the recession would be L-shaped. Anyone buying Deere was looking for a way to capture an economic turnaround.