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When the stock market begins to plummet, one of the most popular questions investors ask is, "Should I use stop loss orders?" I use stop loss orders for my trading service Quantum Growth, but NOT for any of my other services, Global Growth, Emerging Growth or Blue Chip Growth. There is a widespread perception that investors should use stop loss orders to protect their portfolios from downside volatility. The short answer is, sometimes. Let me being by explaining just what a stop loss is, and when are the best times to use it.

What is a stop loss order?

A stop loss order is a sell order that is triggered automatically when your stock reaches a set price.

Let's say for instance we bought 100 shares of Apple (AAPL) stock at $135. Many investors would then enter an order to sell if the stock would fall 10%, or down to $121.50. On the surface that seems to make sense. We won't lose more than 10% if the stock market should fall. But it is exactly the wrong thing to do if you are a long-term investor. One of the greatest truths about markets is that they fluctuate.

In fact, with the example of Apple, prices did fall all the way down to 115. An investor with a stop loss would have sold the stock at 121.50, losing $135. However an investor who rode out the fluctuations saw the price of Apple, a high-quality stock with all the features I look for when investing, rebounded all the way back up $130, so there would have been no loss in holding it.

Like many things in life, stop loss orders appear to make sense at first glance but the reality is that they will usually have investors selling at exactly the wrong time. I think long-term growth investors can protect themselves from stock market fluctuations by following the rules of 60-30-10 and using the zig-zag principles when it comes to stock investing.

There is, of course, an exception to every rule. Shorter-term investors should use stop losses. In my shorter-term trading service, Quantum Growth, I do suggest the use of stop losses. Rather than use a fixed percentage I set the stop losses for these stocks based on their actual trading ranges by calculating the volatility of each stock. Using stop losses in short-term trading enables us to stockpile cash and step aside in those brief periods when the market is not going our way. But, again if you are a long-term tax-efficient investor, stop losses are best avoided.

What is a limit order?

Another question I get a lot when it comes to placing buy/sell orders is the use of limit orders. A limit order is simply an order to buy at no higher than a set price or sell at an order no less than a certain price.

The use of limit orders is based on the type of stock you are buying. In a highly liquid stock that trades very heavily, I think one can just buy at the market price (of course, I set specific Buy Below prices for my subscribers to maximize their entry point into our recommended stocks). The bid-ask spreads tend to be very small, and there is usually plenty of stock for sale.

However, with smaller stocks that are less liquid and thus more volatile, I think that in this age of decimalization, one has to use limit orders. As switching from fractions to decimals for stock pricing phased in, the profit margins to dealers became much smaller and they were far less willing to inventory stocks for sale. Today the Electronic Communications Networks, or ECN's, dominate the marketplace. ECN's are an auction market with buy and sell orders matched. They do not inventory stock like the broker dealers used to, so if there is no matching sell order for your buy, prices go up until they find a match.

As a result, in these smaller stocks, there is less stock for sale at any given time, and a market order could quickly clean out inventory for sale and cause the price to leap rather dramatically. The result would be, you'd pay a much higher price for your shares than the stock was trading for when you entered your order. Obviously, this can have a disastrous impact on your long-term returns. The risk of using limit orders is, of course, that you aren't able to buy stock at your price. With these smaller more volatile stocks, this is probably a good thing. With the more aggressive, thinly traded stocks we have to maintain our buy and sell discipline and have to be willing to miss one once in awhile. The occasional missed stock is a much better problem to have than frequently overpaying for stocks!

Bottom line: Stop Loss and Limit Orders have their place in stock market investing: The key is to know when they are a "do" versus when they are a definite "don't."

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