A stop-loss order is a tactical tool used by traders to limit potential losses or secure profits on an existing position. By implementing stop-loss orders, traders can adeptly manage their exposure to market volatility.
Defining Stop-Loss Orders
Stop-loss orders consist of instructions to sell or buy a security when it reaches a predetermined price, known as the stop price. Once this stop price is hit, the order becomes a market order, ensuring execution at the best possible price.
Unlike stop-limit orders, which require a specific execution price and might not execute at all, stop-loss orders guarantee execution, provided there are available buyers or sellers.
For example, a trader may purchase a stock and place a stop-loss order 10% below the stock’s purchase price. If the stock’s price drops by 10%, the stop-loss is triggered, and the stock is sold at the best available price.
Stop-loss orders are not just for long positions; they effectively protect short positions too. In a short position scenario, the order will close out the position with an offsetting buy if the security’s price reaches a certain level.
Key Takeaways
- A stop-loss order enables the buying or selling of a stock upon reaching a specific price known as the stop price.
- Upon hitting the stop price, the stop order converts to a market order and is quickly executed at the next available opportunity.
- Stop-loss orders are designed to manage losses or secure profits in existing positions.
- They provide protection for both long and short positions.
- Distinct from a stop-limit order, a stop-loss order guarantees execution without the need for a specific price.
How Stop-Loss Orders Work
Investors and traders frequently use stop-loss orders to curtail losses and protect gains. By placing a stop-loss order, you can exit a position if adverse market movements occur, mitigating potential losses.
A sell stop-loss order directs a broker to sell a security once its market price drops to or below a certain threshold. Conversely, a buy stop-loss order sets the stop price higher than the current market price.
Advantage Over a Stop-Limit Order
A stop-loss order turns into a market order at the specified stop price to sell or buy at the best available price. Although a stop-limit order activates at the stop price, it may not execute if the limit isn’t met. The stop-loss order eliminates the risk of an un-closed position even as the stock price plummets.
Potential Disadvantages
One downside of stop-loss orders is vulnerability to price gaps. If a stock’s price suddenly drops below (or above) the stop price, the order triggers, but the stock might trade at a price significantly off from the stop loss mark. Another issue is being stopped out in volatile markets that might reverse direction, resuming the originally beneficial trend.
Incorporating a trailing stop into stop-loss orders provides more flexibility. Trailing stops adjust the stop price by a specified margin relative to the current market price, rising with gains for locking in profits while protecting against downside risks.
Some traders might prefer using option contracts instead of stop orders to manage exit points more precisely.
Benefits of Stop-Loss Orders
- Risk Management: Automatically limits potential losses.
- Profit Preservation: Helps lock in earned profits.
- Strategic Discipline: Promotes discipline and removes emotion from trades.
- Convenient Oversight: Reduces the need for constant market monitoring.
Examples of Stop-Loss Orders
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Example 1
A trader buys 100 shares of ABC Co. at $100 each and sets a stop-loss order at $90. The stock declines below $90 after a couple of weeks. The stop-loss triggers and the stock sells at $89.95, incurring a minor loss, while the market continues to decrease.
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Example 2
A trader purchases 500 shares of XYZ Ltd. at $50 each, setting a stop-loss order at $45. Due to poor earnings release after market hours, the stock opens at the next trading session with a gap down to $35, triggering the stop-loss. The order executes at $34.90, leading to a larger-than-expected loss but still minimizing the continued decline towards a $25 close.
Frequently Asked Questions
What is a Stop-Loss Order?
A stop-loss order is an instruction to close out your position—trading through buying or selling stocks—when prices reach a specified level that incurs minimal acceptable loss.
How Does a Stop-Loss Order Limit Loss?
By automatically selling or buying a position when market prices dip to or through the set stop price, stop-loss helps in minimizing losses. When coupled with a trailing stop, it even provides additional flexibility by following the stock’s upward movements to capture more gains without taking on extra risks.
Do Long-Term Investors Need Stop-Loss Orders?
Typically, long-term investors should ride out market fluctuations. However, evaluating market downturns can reveal opportunities for adding positions or making other strategic adjustments.
Related Terms: stop-limit order, trailing stop, short position, market order.
