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What is a Stop-Loss Order? Definition and Examples

what-is-a-stop-loss-order

This guide will investigate stop-loss orders and how they work, give examples, and examine how this tool differs from others that traders use to mitigate risks when trading stocks, as well as point out the pros and cons of using this particular order option. 


What is a stop-loss order?

There are two types of stop-loss orders: a sell-stop order to protect long positions and a buy-stop order to limit losses on short positions. A sell-stop order is a market order that will be executed if the price falls below a certain level. Conversely, a buy-stop order is set above the current market value and becomes active once the price exceeds that level. 

Unlike stop-limit orders, stop-loss orders guarantee order execution (provided there are buyers and sellers for the asset). However, price fluctuation and price slippage (the difference in price between what you expected to pay for a trade and the actual amount you paid) frequently occur upon execution. For example, most sell-stop orders are executed at a price below the limit price. This is because if the price is falling quickly, an order may get filled for a considerably lower price. 

Recommended video: Using stop orders explained by TDAmeritrade

Source: YouTube TDAmeritrade

Investing for beginners:


Stop-loss order example

Suppose you buy 100 shares of stock X at $50, expecting the price to rise. However, in case your forecast is incorrect, you place a stop-loss order at $40 to sell the shares. Unfortunately, the stock declines over the next few days and drops below $40. Fortunately, your stop-loss order is activated, and the stock is sold at $39.95 for a minor loss (while the market resumes its downward trajectory).

Because a stop-loss order can’t guarantee an execution price (only the best available transaction price), the order might be filled much lower than the intended price. For example, you buy 100 shares of stock X for $50 and set a stop-loss order for $45. Then, after the market closes, unfavorable company announcements see the stock plummet. As a result, when the market opens the next day, stock X has significantly gapped down (a chart pattern whereby the stock opens below the previous day’s close with no trading activity in between).

And so your stop-loss order is triggered but gets executed for $25.00 for a substantial loss. However, the stock continues dropping and closes at $17.00. So ultimately, despite falling short of the trader’s intended goal, the stop-loss order substantially minimized losses that could have been much greater.

How does a stop-loss order work?

A stop-loss order is meant to protect you from loss (by triggering an exit from your position) if the market moves too far in the wrong direction. Stop-loss orders can be either buy or sell orders and only get filled once triggered. When the stop (trigger) price is breached, the stop order turns into a market order. 

Stop orders are always executed if the price reaches the specified level. However, while stop-loss orders guarantee an exit from the losing trade, they won’t necessarily be filled at the desired price since the order can only be filled at the best prevailing market price, which might be less than anticipated. 

Traders should carefully consider where to place the stop-loss order. The optimal place will allow for some flexibility but will also get you out of a position if the price turns in an unfavorable direction. For example, to protect against excessive losses on a sale, traders may set up a sell-stop order below the current market price. In contrast, a buy-stop order can be placed above the current market rate to acquire stock before it gets too costly.

Three order types in stock trading you should know

Before you delve into trading stocks, it’s crucial to understand the different types of orders and when they should be employed. By learning about the advantages and disadvantages of various kinds of orders, you can avoid accidentally experiencing losses and ensure that your trades are processed quickly, and at a price you’re comfortable with.

The most common order types in stock trading are:

  • Market orders; 
  • Limit orders; 
  • Stop orders.

Market order

A market order is the most common order type, and brokerages will typically enter your order as a market order unless you indicate otherwise. A market order is a command to buy or sell a stock immediately. An order of this type guarantees the execution but not the price at which the order will be executed.

A market order is a trade executed at or near the current bid (sell order) or ask (buy order) price in the marketplace during regular trading hours. Unfortunately, however, in rapidly-changing markets, the price you saw or quoted might differ from what you get. 

Lastly, investors should be mindful of unexpected changes in stock prices if they place their trade during after-hours trading.

Limit order

A limit order is buying or selling a stock at a predetermined price or better. The order is only triggered once the desired market price is achieved and is not guaranteed to be filled. For example, if you place a buy limit order, the trade will only be executed if the stock reaches your specified price or falls below it. Conversely, if you place a sell limit order, the trade will only go through if the stock hits your stated price or rises above it.

In short, you’re establishing a limit and affirming that you don’t want to buy stocks above a certain point or sell them below a specific value.

Stop order

A stop order is an instruction to buy or sell a security once its price moves past a specific point, known as the “stop price.” When the stop price is reached, the order transitions into a market order and is executed at the current market price, there are various kinds of stop orders: 

  • Sell/buy stop order, i.e., stop-loss order: If the security is declining in price, the stop order will be to sell at a specified price below the present market value. On the other hand, if the price goes up, the stop order will be to buy once it reaches the designated amount above its current market worth;
  • Stop-limit order: If you don’t want your stop order to result in a market order, you can switch to a stop-limit order instead. In this type of order, your stop order activates a limit order. Stop-limit orders allow the investor to set the price at which the order is filled, but they cannot guarantee execution. They are a crucial safety measure to maximize the protection of your trading strategy and position; 
  • Trailing stop-loss orders: A trailing stop-loss order is a stop-loss order that automatically closes a trade if the price changes direction by a set percentage or dollar amount. A trailing stop-loss is placed below the current market price for a long position and above the current market price for a short position. A trailing stop-order is similar to a traditional stop-loss order, except it automatically follows the stock’s performance, allowing the investor to keep their trade open and continue profiting as long as the price moves favorably. 

Stop orders are a tool that investors use to manage market risk and a convenient way to avoid frequently checking the market to sell (or buy) once a specific price target is reached.

Recommended video: Limit orders, market orders, and stop orders explained

Source: YouTube TDAmeritrade

Order time frames and conditions

Different duration types and conditions can be applied to market, limit, and stop orders that determine how long the order stays in the market before it gets executed or canceled, including:  

  • Day order: A market or limit order that will no longer be active at the end of the trading day if it has not been executed;
  • Good-til-Canceled (GTC): A limit order that remains valid in future market sessions until it is triggered or canceled;
  • A Market-on-Open (MOO): A market order to be executed at the day’s opening price;
  • A Market-on-Close (MOC): A market order to be executed as near to the closing price as possible;
  • Immediate-or-Cancel (IOC): A market or limit order to be executed immediately, full or in part (the part that remains unfilled will be canceled);
  • All or none (AON): A market or limit order to be executed in full or canceled; partial fills are not allowed;
  • A fill or kill (FOK): A market or limit order that combines IOC and AON to execute immediately and completely or not at all. 

​​Limit vs stop-limit

A limit order is an instruction to buy or sell a stock at a price that you specify or better. For example, if you want to buy a $50 stock at $48 per share, your limit order will be filled once sellers are willing to meet that price. In contrast, a stop-limit order incorporates the elements of a limit order and a stop order and sees the limit order placed only after the stop price has been triggered. Therefore, a stop-limit order needs both a stop price and a limit price, which might be the same or different. 

Stop-loss order vs market order

A market order will immediately trigger the purchase or sale of an asset at its current market value. A stop-loss order allows you to postpone the transaction until the security reaches your desired price. Both order types guarantee order execution. 

Stop-loss vs stop-limit

While a stop-loss order guarantees execution, a stop-limit order assures a fill at the desired price.

In a stop-loss order, if the price triggers the stop, a market order will be executed. However, should the order be a stop-limit, a limit order will be issued subject to the stop price being triggered and can then only be filled at the limit price or better. Therefore, to carry out a stop-limit order, both a limit price and a stop price must be set.

Ultimately, stop-limit orders may not be executed, while stop-loss orders are guaranteed (provided there are buyers and sellers).

Recommended video: Stop and stop-limit orders

Source: YouTube Charles Schwab

Pros and cons of stop-loss orders 

Weigh the pros and cons of a stop-loss order before deciding whether it’s the right strategy for you.

Pros

Pros

  • Versatility: can be applied for both buy and sell orders;
  • Preventing losses: Stop-orders can protect you from taking a loss as long as the stop price is triggered and there’s enough time to execute an order before markets close;
  • No partial fills: A stop-loss order is guaranteed to be filled;
  • Free insurance on your trades: Brokers don’t charge for setting up stop-loss orders (although some still charge commissions on the actual trades);
  • Convenience: Stop-loss orders provide the convenience of not having to track your stocks daily, saving you time and effort;
  • Discipline: Stop-loss orders enable investors to make pre-determined decisions to sell, which helps them avoid letting their emotions cloud their investment decisions. 
Cons

Cons

  • The price is not guaranteed: When your stop price is reached, your stop order will be instantly executed as a market order at the prevailing market rate. Consequently, you may suffer from unforeseen losses if the exit price deviates from the stop price;
  • Unnecessary triggers in volatile markets: Short-term price fluctuation could activate the stop and trigger an undue sale, particularly true in fast-moving, volatile markets or in the case of unfavorable news announcements. 

In conclusion 

Whether you’re seeking to secure profits or safeguard against significant losses, nearly all investment strategies can benefit from implementing a stop-loss order. However, though stop-loss orders may appear relatively straightforward, educating yourself about the potential disadvantages of this method is imperative before enforcing them as part of your risk management strategy.

FAQs about stop-loss orders

What is a stop-loss order?

A stop-loss order is an instruction to buy or sell a security once it reaches a specific price, at which point the stop order becomes a market order and is fulfilled immediately. 

Why use a stop-loss order?

The primary purposes of a stop-loss order are to mitigate risk by exiting trades once the market moves unfavorably and to make trading more streamlined by having automatic trades in place that execute at a specified price.

What is the difference between a stop-loss order vs a stop-limit order?

Stop-loss orders execute immediately at the market after the stop price has been hit. Stop-limit orders, on the other hand, turn into limit orders that will only be filled at the set price or better (i.e., there is no guarantee of execution). In short, stop-loss orders guarantee execution, while stop-limit orders guarantee the execution price. 

When can stop-loss orders be used?

Stop-loss orders can only be triggered during regular market hours. Therefore, they will not go through when the market is closed over weekends or holidays.

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