A stop-loss order is a simple tool that can offer significant advantages when used effectively. Whether to prevent excessive losses or to lock in profits, nearly all investing styles can benefit from this tool. Think of a stop-loss as an insurance policy: You hope you never have to use it, but it’s good to know you have the protection should you need it.
The main purposes of a stop-loss order are to reduce risk exposure (by limiting potential losses) and to make trading easier (by already having an order in place that will automatically be executed if the market trades at a specified price).
Traders are strongly urged to always use stop-loss orders whenever they enter a trade, in order to limit their risk and avoid a potentially catastrophic loss. In short, stop-loss orders serve to make trading less risky by limiting the amount of capital risked on any single trade.
- How does the Stop-loss Order Work?
- What’s the Difference Between Stop-loss and Limit Order?
- What is a Good Stop-loss Order?
- When Should you Stop-loss?
- How Stop-loss Works With Example?
What Is a Stop-Loss Order?
A stop-loss order is an order placed with a broker to buy or sell a specific stock once the stock reaches a certain price. A stop-loss is designed to limit an investor’s loss on a security position. For example, setting a stop-loss order for 10% below the price at which you bought the stock will limit your loss to 10%.
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Suppose you just purchased Microsoft (MSFT) at $20 per share. Right after buying the stock, you enter a stop-loss order for $18. If the stock falls below $18, your shares will then be sold at the prevailing market price.
Stop-limit orders are similar to stop-loss orders. However, as their name states, there is a limit on the price at which they will execute. There are then two prices specified in a stop-limit order: the stop price, which will convert the order to a sell order, and the limit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price (or better).
With a stop-loss order, an investor enters an order to exit a trading position that he holds if the price of his investment moves to a certain level that represents a specified amount of loss in the trade. By using a stop-loss order, a trader limits his risk in the trade to a set amount in the event that the market moves against him.
For example, a trader who buys shares of stock at $25 per share might enter a stop-loss order to sell his shares, closing out the trade, at $20 per share. It effectively limits his risk on the investment to a maximum loss of $5 per share.
If the stock price falls to $20 per share, the order will automatically be executed, closing out the trade. Stop-loss orders can be especially helpful in the event of a sudden and substantial price movement against a trader’s position.
How does the Stop-loss Order Work?
Stop-loss orders can also be used to lock in a certain amount of profit in a trade. For example, if a trader has bought a stock at $2 a share and the price subsequently rises to $5 a share, he might place a stop-loss order at $3 a share, locking in a $1 per share profit in the event that the price of the stock falls back down to $3 a share.
It’s important to understand that stop-loss orders differ from limit orders that are only executed if the security can be bought (or sold) at a specified price or better. When the price level of a security moves to – or beyond – the specified stop-loss order price, the stop-loss order immediately becomes a market order to buy or sell at the best available price.
Therefore, in a rapidly moving market, a stop-loss order may not be filled at exactly the specified stop price level, but will usually be filled fairly close to the specified stop price. But traders should clearly understand that in some extreme instances stop-loss orders may not provide much protection.
For example, let’s say a trader has purchased a stock at $20 per share and placed a stop-loss order at $18 a share, and the stock closes on one trading day at $21 a share. Then, after the close of trading for the day, catastrophic news about the company comes out.
If the stock price gaps lower on the market open the next trading day – say, with a trading opening at $10 a share – then the trader’s $18 a share stop-loss order will immediately be triggered because the price has fallen to below the stop-loss order price, but it will not be filled anywhere close to $18 a share. Instead, it will be filled around the prevailing market price of $10 per share.
With limit orders, your order is guaranteed to be filled at the specified order price or better. The only guarantee if a stop-loss order is triggered is that the order will be immediately executed, and filled at the prevailing market price at that time.
What’s the Difference Between Stop-loss and Limit Order?
A stop order is an order to buy or sell a stock at the market price once the stock has traded at or through a specified price (the “stop price”). If the stock reaches the stop price, the order becomes a market order and is filled at the next available market price. If the stock fails to reach the stop price, the order is not executed.
A stop order may be appropriate in these scenarios:
- When a stock you own has risen and you want to attempt to protect your gain should it begin to fall
- When you want to buy a stock as it breaks out above a certain level, believing that it will continue to rise
A sell-stop order is sometimes referred to as a “stop-loss” order because it can be used to help protect an unrealized gain or seek to minimize a loss. A sell-stop order is entered at a stop price below the current market price; if the stock drops to the stop price (or trades below it), the stop order to sell is triggered and becomes a market order to be executed at the market’s current price. This sell-stop order is not guaranteed to execute near your stop price.
A stop order may also be used to buy. A buy-stop order is entered at a stop price above the current market price (in essence “stopping” the stock from getting away from you as it rises).
Let’s revisit our previous example, but look at the potential impacts of using a stop order to buy and a stop order to sell–with the stop prices the same as the limit prices previously used.
While the two graphs may look similar, note that the position of the red and green arrows is reversed: the stop order to sell would trigger when the stock price hits $133 (or below), and would be executed as a market order at the current price.
So, if the stock were to fall further after hitting the stop price, it’s possible that the order could be executed at a price that’s lower than the stop price. Conversely, for the stop order to buy, once the stop price of $142 is reached, the order could be executed at a higher price.
What is a limit order
A limit order is an order to buy or sell a stock with a restriction on the maximum price to be paid or the minimum price to be received (the “limit price”). If the order is filled, it will only be at the specified limit price or better. However, there is no assurance of execution. A limit order may be appropriate when you think you can buy at a price lower than–or sell at a price higher than–the current quote.
The above chart illustrates the use of market orders versus limit orders. In this example, the last trade price was roughly $139.
- A trader who wants to purchase (or sell) the stock as quickly as possible would place a market order, which would in most cases be executed immediately at or near the stock’s current price of $139 (white line)–provided that the market was open when the order was placed and barring unusual market conditions.
- A trader who wants to buy the stock when it dropped to $133 would place a buy limit order with a limit price of $133 (green line). If the stock falls to $133 or lower, the limit order would be triggered and the order would be executed at $133 or below. If the stock fails to fall to $133 or below, no execution would occur.
- A trader who wants to sell the stock when it reached $142 would place a sell limit order with a limit price of $142 (red line). If the stock rises to $142 or higher, the limit order would be triggered and the order would be executed at $142 or above. If the stock fails to rise to $142 or above, no execution would occur.
Note, even if the stock reaches the specified limit price, your order may not be filled, because there may be orders ahead of yours that eliminate the availability of shares at the limit price. (Limit orders are generally executed on a first-come, first served basis.) Also note that with a limit order, the price at which the order is executed can be lower than the limit price, in the case of a buy order, or higher than the limit price, in the case of a sell order.
If the limit order to buy at $133 was set as “Good ’til Canceled,” rather than “Day Only,” it would still be in effect the following trading day. If the stock were to open at $130, the buy limit order would be triggered and the purchase price expected to be around $130–a more favorable price to the buyer.
Conversely, with the sell limit order at $142, if the stock were to open at $145, the limit order would be triggered and be filled at a price close to $145–again, more favorable to the seller.
What is a Good Stop-loss Order?
Stocks are a tricky business, especially when the market is volatile. When you have money in an investment, you want to be sure it is benefiting you. Falling stock prices mean you could lose money on your investments, which is something all investors want to avoid.
Establishing a stop-loss
To reduce the risk of losing money, many people use stop-loss orders. These are specific instructions to sell your position if the price ever drops to a predetermined amount. They protect investors from losing more money than they can afford to.
Here’s how they work: If you purchase a stock at a certain amount of money, say $20, and you want to make sure you don’t lose more than 5 percent of your investment, you’ll want to set your stop-loss order at $19. If the stock falls to $19 or below, it is automatically sold at the best market price at the moment.
According to Stock Trader, there are many reasons a person would want to set stop-loss order. Doing so allows the trader to focus on other matters in his or her life, even during times of market volatility. This is because stop-losses don’t need the investor to be present; they are completely automated.
Investors also like this technique because it removes all emotion and the possibility of overthinking a sell. Investing can become an emotional trigger for some, resulting in poor practice and, eventually, loss. Creating a stop-loss is purely logical, which is important in an industry that requires discipline to succeed.
ABC News recommended that all investors establish their stop-loss orders immediately after buying their stocks. Stock Trader explained that stop-loss orders should never be set above 5 percent. This is to avoid selling unnecessarily during small fluctuations in the market.
Realistically, a stock could fall by 5 percent midday but rebound. You wouldn’t want to sell prematurely and lose out on potential gains. ABC News noted that lower percentage increments should be issued for fixed-income investments, like bonds. On the other hand, stop-losses on emerging market opportunities will typically be set at higher price increments.
Also, it’s important to set stop-losses at common prices. A stock may never reach an obscure price, such as an odd dollar amount or an amount that isn’t divisible by quarters.
When not to use a stop-loss
According to Stock Trader, there are some instances when a stop-loss order isn’t helpful, and others when it may actually be harmful to the trader’s investment.
If an investor is an active trader dedicated to his or her stocks and constantly watching the market, and ready at any time to buy or sell, a stop-loss order is essentially pointless. The trader likely knows when the stock is reaching the threshold for more loss than wanted and will sell it when the time is right.
Michael Sincere, a columnist for Marketwatch, explained he stopped using stop-losses altogether when he realized he could execute sales in an efficient and timely manner by taking advantage of technology. Instead, he has price alerts for those amounts he would have previously set his stop-losses at. When a stock he owns reaches the limit, he gets an email and a text message. He is able to immediately access his properties and decide to sell, or not.
Sincere explained he likes this strategy better because it protects his stocks from abnormal market fluctuations that are likely to correct themselves. If a stop-loss is in play during these times, the investor could wind up losing more money than expected, if the stock is sold at a much lower price.
It also provides protection against stocks that are forced down in order to trigger a large group of stop-losses. In these instances, the price will likely begin to increase shortly after.
However, he did note that, if an investor has limited access to his or her stocks, such as during travel or vacation, a stop-loss will add a layer of protection against major losses. Also, if a trader knows he or she won’t promptly respond to the price alert, a stop-loss might be a better strategy.
The objective of investing in the stock market is to make money – not lose it. A stop-loss can be viewed as a sort of insurance against falling stock prices.
When Should you Stop-loss?
One should generally place a stop loss in trading at the low of the most recent candlestick when they are buying the stock. Similarly, one should place a stop loss in trading at the high of the most recent candlestick when they are selling the stock.
Here are some more ways of determining the stop loss levels:
1. Support levels:
Support levels are often used by traders to determine stop-loss levels.
In the weekly chart of State Bank of India we can place a stop loss in trading at the 235 support level, if this level is broken then our stop loss order will be executed at Rs. 235.
2. Percentage Method:
Another method of placing a stop loss in trading is through the percentage method.
For example, if you can take a loss of 10% based on your risk appetite. Then you can place a stop loss price at 10% lower than the buying price.
3. Through technical indicators:
Traders often use technical indicators to determine to stop loss levels.
In this daily chart of State Bank of India, we have places stop loss at the low of 20 MA which is the longer period in this setup.
4. Fibonacci Retracement levels:
Fibonacci Retracement levels can also be used to determine to stop loss levels. Above are some of the ways of placing stop loss for your trades but a trader should put stop loss price based on his trading strategy.
How Stop-loss Works With Example?
Stop-loss orders are orders with instructions to close out a position by buying or selling a security at the market when it reaches a certain price known as the stop price.
They are different from stop-limit orders, which are orders to buy or sell at a specific price once the security’s price reaches a certain stop price. Stop-limit orders may not get executed whereas a stop-loss order will always be executed (assuming there are buyers and sellers for the security).
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For example, a trader may buy a stock and place a stop-loss order with a stop 10% below the stock’s purchase price. Should the stock price drop to that 10% level, the stop-loss order is triggered and the stock would be sold at the best available price.
Although most investors associate a stop-loss order with a long position, it can also protect a short position. In such a case, the position gets closed out through an offsetting purchase if the security trades at or above a specific price.
Traders or investors may choose to use a stop-loss order to limit their losses and protect their profits. By placing a stop-loss order, they can manage risk by exiting a position if the price for their security starts moving in the direction opposite to the position that they’ve taken.
A stop-loss order to sell is a customer order that instructs a broker to sell a security if the market price for it drops to or below a specified stop price. A stop-loss order to buy sets the stop price above the current market price.
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.