What Is a Stop-Loss Order?
A stop-loss order is a critical tool for traders aiming to curtail potential losses or secure gains from their existing positions. By dictating that a security is bought or sold at market when it hits a predetermined stop price, traders can effectively manage and limit risk exposure. Unlike a stop-limit order, which might not execute, a stop-loss order guarantees execution (provided there are market participants) when the stop price is met.
This method of risk management is essential in volatile markets, offering a safeguard when prices move unfavorably. For instance, if a stock you own depreciates by a set percentage, a stop-loss order helps ensure it is sold at the best available price, protecting your investment portfolio from further downfall.
Key Takeaways
- A stop-loss order is designed to limit investor losses by automatically selling a security when its price reaches a predefined level.
- Unlike stop-limit orders, stop-loss orders guarantee execution but may result in sales at less favorable prices during price gaps.
- Utilizing stop-loss orders can help investors manage risk by exiting positions when a market moves against their interests.
- Combining stop-loss orders with trailing stops allows investors to protect profits while mitigating downside risks.
- Long-term investors might not need stop-loss orders as they tend to wait out market fluctuations, potentially using downturns as buying opportunities.
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Understanding How Stop-Loss Orders Function
Traders use stop-loss orders to limit losses and protect profits, allowing them to exit if a security’s price moves against their position.
A stop-loss order to sell tells a broker to sell if a security’s market price drops to or below the stop price. Conversely, a stop-loss order to buy is set above the current market price.
Why Choose Stop-Loss Orders Over Stop-Limit Orders?
When a security hits the stop price, a stop-loss order becomes a market order to sell at the best price available. Meanwhile, a stop-limit order might not execute if the security doesn’t reach the limit price, so stop-loss orders help ensure the position closes even if prices drop further.
Disadvantages of Using Stop-Loss Orders
A downside to stop-loss orders is price gaps. If a stock’s price gaps past the stop price, the order triggers, and the stock is sold (or bought) at the next available price, regardless of a sharp price move.
Another disadvantage concerns getting stopped out in a choppy market that quickly reverses itself and resumes in the direction that was beneficial to your position.
Investors can use a trailing stop with a stop-loss order for more flexibility. A trailing stop adjusts its stop price based on a set percentage or amount above or below the market price, locking in profits as prices rise while protecting against losses.
Traders might also use option contracts instead of stop orders to better control their exit price points.
Advantages 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 is triggered, and the position is sold at $89.95, resulting in a minor loss. The market continues trending downward.
A trader buys 500 shares of ABC at $100, setting a stop-loss at $90. After bad earnings are reported, the price drops at opening. The stop-loss triggers at $90, limiting the loss despite the market dropping further to close at $49.50.
What’s a Stop-Loss Order?
It’s an order placed once you’ve taken a position in a security (on the buy side or sell side) with instructions to close out your position by selling (or buying) the security at the market if the price of the security reaches a specific level.
How Does a Stop-Loss Order Limit Loss?
A stop-loss order limits your exposure to less of a loss than you might otherwise experience by automatically closing out your position if your stock trades to an unfavorable market price level that you designate. If you use a trailing stop with your stop-loss order, that protection can move with your position even as it increases in value. So, a loss could translate to less profit rather than a complete loss.
Do Long-Term Investors Need Stop-Loss Orders?
Probably not. Long-term investors shouldn’t be overly concerned with market fluctuations because they’re in the market for the long haul and can wait for it to recover from downturns. However, they can and should evaluate market drops to determine if some action is called for. For example, a downturn could provide the opportunity to add to their positions, rather than to exit them.