Our writers and editors used an internal natural language generation platform to assist with parts of this article, allowing them to focus on adding information that’s particularly useful. The article was reviewed, fact-checked and edited by our editorial staff before publication.
A stop-loss order is intended to limit an investor’s loss or protect an unrealized gain on a security position. When a stock reaches a predetermined price, the stop-loss order is automatically triggered, placing a market order to sell (or short buy) the stock. The stock is then sold at the best available price, which may differ from the initially established stop price. Stop-loss orders cost nothing to set up and can be useful for limiting losses if a stock’s price drops unexpectedly.
Here you can read how stop-loss orders work, the pros and cons of using them and the different types of orders.
How a stop-loss order works
A trader places a stop-loss order with a broker to buy or sell a security when it reaches a certain price. The purpose of this type of order is to minimize potential losses by automatically selling the security if its price falls below a certain level, or buying a security when it reaches a certain price.
The order is set at a certain price, known as the stop price, and becomes active when the stock price reaches that level. At that point, the stop-loss order becomes a market order and the stock is sold at the best available price, which may differ from the stop price. Investors can help manage risks and limit losses with this type of trading strategy.
A stop-loss can be used to limit an investor’s downside risk in a particular investment. You can use this to protect a nice profit or to quickly exit a position that starts moving lower.
–Greg McBride | Chief Financial Analyst at Bankrate
Example of a stop-loss order
Here is an example to illustrate the concept of the stop-loss order. Suppose you buy XYZ stock at $50 per share and want to limit your loss to 10 percent. You can place a stop-loss order with your broker to sell the stock when the price reaches $45.
If the stock falls to $45, the order is triggered and becomes a market order. The sale will be made at the best available price, which may not necessarily be $45 if the stock price falls quickly. If the order is filled at $45, you will have a 10 percent loss.
Trailing stop orders
Another type of stop-loss order is called a trailing stop order. In this type of order, an investor sets a certain percentage or price above or below the current market price. If the market price of the security moves in a favorable direction, the trailing price follows suit and is adjusted by the specific amount. If the market price does not move favorably, the trailing price remains fixed and a market order is triggered when the stock price reaches the trailing stop price.
Let’s go back to the previous example. You buy XYZ stock for $50 and set a trailing stop order at $5 below the market price. If the stock reaches $45, a sell order will be triggered. However, suppose the stock rises to $55. The price of the trailing stop order would rise to $50, meaning that if the stock falls from $55 to $50, the order will result in a sale of the stock. If the price continues to rise, the trailing stop order will continue to rise until it is activated or until the order validity expires on a good to canceled order, often three months.
The trailing stop order adjusts your stop price and automatically protects your shares from further loss as stocks rise.
Benefits of stop-loss orders
Here are some reasons to consider adding stop-loss orders to your investing strategy:
- Limit losses
- In a sense, a stop-loss order is essentially a free insurance policy. If the price of a stock drops unexpectedly, a stop-loss order will help limit your losses.
- No costs to implement
- There are no costs associated with placing a stop-loss order. The only fees charged are if the stop price is reached and a market order occurs, which may result in transaction fees.
- Checks the price
- Investors can help determine the price at which the order will be executed and set it as low or high as they wish. While you may have to sell at a different price than you want (see the slippage in the next section), you may be better off than an investor who has not set any stop orders.
- Gives time back to an investor
- Investors who are busy with other responsibilities can place the order and move on, knowing that the order will be placed to hopefully help prevent losses. Stop-loss orders can help prevent investors from monitoring stocks on a daily basis and reacting emotionally to price movements. Having a strategy that includes stop-loss orders provides a plan for exiting losing positions.
Disadvantages of stop-loss orders
Stop-loss orders involve a number of risks. Here you can read what you should take into account:
- Market fluctuations and volatility
- Stop-loss orders can result in unnecessary selling or buying when there are temporary fluctuations in the stock price, especially short-term intraday price movements. Greg McBride, Bankrate’s Chief Financial Analyst, says: “Think carefully about how and at what point you set a stop-loss order, as it can easily be triggered by a short-term overreaction in the stock price that may not be indicative of a deterioration in the share price. basics. In this case, the price could recover quickly, but you would be out of position if that were to happen.”
- Slipping
- Stop-loss orders can be subject to slippage, or the difference between the price at which the order is triggered and the actual price at which it is executed, especially in a highly volatile market or on a thinly traded stock. Because a stop order becomes a market order once the stop price is reached and does not occur immediately, the actual price at which you sell or buy may differ from the original stop price.
- No guaranteed profit
- A stop-loss order does not guarantee that you will make money on a trade.
- Not always available
- Stop-loss orders may not be available for certain stocks, and some brokers do not allow these types of orders to be placed for certain securities.
What is the difference between a stop-loss order and a stop-limit order?
Stop-loss orders and stop-limit orders are both used to control losses in trading. While stop-loss orders trigger market orders when a specific price is reached, stop-limit orders trigger limit orders at that price.
The main difference between these two order types is that a stop-limit order guarantees that the order will only be executed at the specified price or better, while a stop-loss order can be executed above or below the original price. This is because a stop-loss order triggers a market order, which trades at the best available price, which may be different from the stop-loss price, as explained above in the slippage section.
In short
Stop-loss orders can be a tool for investors to help limit their losses in the stock market, but they are not a silver bullet that can help in all situations. For best results, investors should be aware of the different order types and understand how they can be used to maximize profits and limit losses.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
