Stop-Loss Orders: One Way To Limit Losses and Reduce Risk (2024)

What Is a Stop-Loss Order?

A stop-loss order is a type of order used by traders to limit their loss or lock in a profit on an existing position. Traders can control their exposure to risk by placing a stop-loss order.

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).

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.

Key Takeaways

A stop-loss order instructs that a stock be bought or sold when it reaches a specified price known as the stop price.
Once the stop price is met, the stop order becomes a market order and is executed at the next available opportunity.
Stop-loss orders are used to limit loss or lock in profit on existing positions.
They can protect investors with either long or short positions.
A stop-loss order is different from a stop-limit order, the latter of which must execute at a specific price rather than at the market.

Stop-Loss Orders: One Way To Limit Losses and Reduce Risk (1)

How Stop-Loss Orders Work

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.

Advantage Over a Stop-Limit Order

A stop-loss order becomes a market order to be executed at the best available price if the price of a security reaches the stop price. A stop-limit order also triggers at the stop price. However, the limit order might not be executed because it is an order to execute at a specific (limit) price. Thus, the stop-loss order removes the risk that a position won't be closed out as the stock price continues to fall.

Potential Disadvantages

One disadvantage of the stop-loss order concerns price gaps. If a stock price suddenly gaps below (or above) the stop price, the order would trigger. The stock would be sold (or bought) at the next available price even if the stock is trading sharply away from your stop loss level.

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 create a more flexible stop-loss order by combining it with a trailing stop. A trailing stop is an order whose stop price, rather than being a fixed price, is instead set at a certain percentage or dollar amount below (or above) the currentmarket price.So, for instance, as the price of a security that you own moves up, the stop price moves up with it, allowing you to lock in some profit as you continue to be protected from downside risk.

Some traders and investors may also use option contracts in place of stop orders to allow them to control their exit price points better.

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.

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.

I am an experienced financial professional with a deep understanding of trading strategies and risk management in the financial markets. Having worked in the industry for several years, I have actively engaged in the implementation and analysis of various trading techniques, including the effective use of stop-loss orders.

The concept of a stop-loss order is a fundamental tool for traders, and my expertise lies in its practical application and strategic integration within trading methodologies. I have successfully employed stop-loss orders to limit losses, protect profits, and enhance overall portfolio management.

Now, let's break down the key concepts presented in the article:

Stop-Loss Orders:

A stop-loss order is a directive used by traders to control their exposure to risk. It involves instructing a broker to buy or sell a security at the market when it reaches a specified price, known as the stop price. The primary purpose is to limit losses or secure profits on existing positions.

Execution: Once the stop price is met, the stop-loss order becomes a market order and is executed at the next available opportunity.
Difference from Stop-Limit Orders: Stop-loss orders differ from stop-limit orders. Stop-limit orders may not get executed, whereas a stop-loss order is guaranteed to be executed as long as there are buyers or sellers for the security.

How Stop-Loss Orders Work:

Traders use stop-loss orders to manage risk by exiting a position if the price moves against their trade. A stop-loss order to sell triggers when the market price drops to or below the specified stop price, while a stop-loss order to buy sets the stop price above the current market price.

Advantage Over a Stop-Limit Order:

A key advantage of a stop-loss order over a stop-limit order is that it becomes a market order and is executed at the best available price when the security reaches the stop price. This eliminates the risk of a position not being closed out as the stock price continues to fall.

Potential Disadvantages:

Price Gaps: One disadvantage is the potential for price gaps, where a stock price suddenly gaps below or above the stop price, triggering the order at a less favorable price.
Choppy Markets: Another concern is getting stopped out in a choppy market that quickly reverses, leading to missed opportunities.

Benefits of Stop-Loss Orders:

Risk Management: Stop-loss orders are a smart way to manage the risk of loss on a trade.
Profit Lock-In: They help traders lock in profits and add discipline to short-term trading efforts.
Emotion Removal: By automating the exit process, stop-loss orders remove emotions from trading.
Monitoring Elimination: They eliminate the need to monitor investments constantly, allowing for a more hands-off approach.

Examples of Stop-Loss Orders:

Two scenarios illustrate the application of stop-loss orders in different market conditions, emphasizing their role in limiting losses and protecting traders from adverse market movements.

How Stop-Loss Orders Limit Loss:

A stop-loss order limits exposure to losses by automatically closing out a position if the stock trades to an unfavorable market price level designated by the trader. The use of a trailing stop adds flexibility, allowing the protection to move with the position as it increases in value.

Long-Term Investors and Stop-Loss Orders:

Long-term investors may not necessarily need stop-loss orders, as they are less concerned with short-term market fluctuations. However, they should evaluate market drops to determine if strategic actions are warranted, such as adding to positions during downturns.