What Is a Stop-Loss Order?

Traders use a stop-loss order to limit loss or secure a profit on a current position. This order helps manage risk.

A stop-loss order instructs to close a position by buying or selling a security when it hits a specific stop price.

This differs from stop-limit orders. Stop-limit orders specify a price for buying or selling once the security reaches the stop price. Unlike stop-loss orders, stop-limit orders might not execute.

For example, a trader buys a stock and sets a 10% stop-loss below the purchase price. If the stock price falls to this level, the order triggers, selling the stock at the best available price.

Stop-loss orders can also protect short positions. In this case, the order buys the security if it trades at or above a specific price.

How Stop-Loss Orders Work

Traders use stop-loss orders to limit losses and guard profits. These orders exit a position if the security’s price moves against their position.

A sell stop-loss order tells a broker to sell if the security’s market price drops to a set stop price. A buy stop-loss order sets the stop price above the current market price.

Advantage Over a Stop-Limit Order

A stop-loss order becomes a market order when the security reaches the stop price. It executes at the best available price. Unlike stop-limit orders, stop-loss orders ensure the position closes, removing the risk of not exiting as the stock price falls.

Potential Disadvantages

Price gaps are one issue with stop-loss orders. If a stock price suddenly gaps beyond the stop price, the order triggers and executes at the next available price. This can deviate sharply from your stop-loss level.

Another issue is getting stopped out in a volatile market that quickly reverses, moving in a direction beneficial to you.

Investors can make stop-loss orders more flexible by using a trailing stop. A trailing stop adjusts the stop price based on the security’s current market price. This locks in profits while protecting against downside risk.

Benefits of Stop-Loss Orders

• Stop-loss orders are a smart and easy way to manage the risk of loss on a trade.
• They can help traders lock in profit.
• Every investor can make them a part of their investment strategy.
• They add discipline to an investor’s short-term trading efforts.
• They take emotions out of trading.
• They eliminate the need to monitor investments on a daily (or hourly) basis.

Examples of Stop-Loss Orders

A trader buys 100 shares of XYZ Company for $100 and sets a stop-loss order at $90. The stock declines over the next few weeks and falls below $90. The trader’s stop-loss order gets triggered and the position is sold at $89.95 for a minor loss. The market continues trending downward.

A trader buys 500 shares of ABC Corporation for $100 and sets a stop-loss order for $90. After the market closes, the business reports unfavorable earnings results. When the market opens the next day, ABC’s stock price gaps down. The trader’s stop-loss order is triggered. The order gets executed at a price of $70.00 for a substantial loss. However, the market continues dropping and closes at 49.50. While the stop-loss order couldn’t protect the trader as originally intended, it still limited the loss to much less than it could have been.