How to Stay Calm, When The Herd Panics

Panic is an ugly beast. Quarterly earnings misses this week by bellwether retail stocks Target (NYSE: TGT) and Walmart (NYSE: WMT) have stoked fears of an imminent recession, clobbering the retail sector and sending the broader markets into a tailspin.

Selling in a panic-driven market is one of the worst and most costly mistakes you can make as an investor. Focusing on fundamentals is a basic tenet of successful investing. Pullbacks represent a good time to build up existing positions in strong companies or buy into stocks that you didn’t get into earlier.

Read This Story: Investors, Take a Deep Breath

Volatility can be scary, but savvy investors can use the market’s mood swings to their advantage by knowing how and when to exercise three types of protective measures when buying. Let’s look at the menu.

Limit Orders

Limit orders help investors avoid buying or selling a stock at a price lower or higher than they desire. It is an order to buy or sell a security at a specific price, as opposed to a market order, which doesn’t guarantee that your security will be purchased or sold at a specific price.

A buy limit order sets the maximum amount you’re willing to pay; a sell limit order sets the minimum amount you’re willing to lose in an investment. Using limit orders can enable investors to take advantage of stock price dips.

Stop-Loss Orders

One of the most widely used devices for limiting the level of loss from a dropping stock is to place a stop-loss order with your broker. Using this stop order, the trader will pre-set the value based on the maximum loss the investor is willing to tolerate.

If the last price drops below this fixed value, the stop loss automatically becomes a market order and gets triggered. As soon as the price falls below the stop level, the position is closed at the current market price, which prevents any additional losses.

Stop-loss orders can save you boatloads of money, particularly if the extended selloff occurs at the peak of a financial crisis.

Trailing Stops

A trailing stop and a regular stop loss appear similar because they equally provide protection of your capital if a stock’s price begins to move against you, but that is where their similarities end.

The “trailing stop” provides an advantage over a conventional stop loss because it’s more flexible. It allows the trader to continue protecting his capital if the price drops, but when the price increases, the trailing feature becomes active, enabling an eventual protection of profit while still reducing the risk to capital.

Over time, the trailing stop will self-adjust, shifting from minimizing losses to protecting profits as the price reaches new highs.

Pros and cons…

These tactics are much riskier in volatile markets. For example, the stop-loss order becomes a market order once the stock hits the designated price threshold. The Flash Crash of 2010 is a prime example of when stop-loss orders should be avoided in volatile markets.

In skittish markets, limit orders are a better option and enable investors to profit from others’ fears. That being said, limit orders involve some risks. It’s possible that the stock in question will never reach the limit price; the farther the order limit is from the current price, the more likely the order will prove worthless and expire. Alternatively, the market price may quickly move past the limit price before the order can be filled.

Trailing stops automatically push sell thresholds higher by a fixed percentage or dollar amount as the stock’s price rises, a seemingly useful service. However, if you’re an investor with a longer time horizon, trailing stops can increase the risk that a bout of volatility can knock you out of your position.

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John Persinos is the editorial director of Investing Daily.

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