One of the biggest draws to the stock market is the potential to generate significant growth and build wealth. Naturally, one of the biggest fears that hold people back is the fear of dramatic declines that result in painful losses. At the same time, making sure to exit your trade when your investment strategy tells you to is crucial, whether the trade is profitable or ends in a manageable loss.
No matter your style of investing, the assets you invest in, or the strategy you’re following, chances are you can benefit from a tool that automatically executes a trade if prices reach a specific point. That tool’s known as the stop-loss order.
Whether you’re a value, growth, or income investor, or even a day trader, the stop-loss is an important tool that you’ll likely benefit from using. But what exactly is it, and how does it work?
What Is a Stop-Loss Order?
When you invest, you’ll do so through a series of market orders placed within your brokerage account. There are several different order types, with the most common being simple buy or sell orders. To buy a stock, you place a buy order; to sell a stock, you place a sell order.
However, some order types are a bit more complex, designed to give you more control over what happens with your money and when you execute the desired trade. The stop-loss order is one of these.
Stop-loss orders are placed within your brokerage account and tell your broker what to do when a specified price — known as the stop price or stop-loss price — is reached in either direction. Once this stock price is reached, your broker carries out the order as you outlined when you placed it.
Stop-loss orders act as a sort of free insurance policy. Once a specific price level is reached, an action is taken in an attempt to protect your wealth. Not taking advantage of the stop-loss would be similar to being offered free homeowners insurance and not taking the time to fill out the paperwork.
Different Types of Stop-Loss Orders
There are multiple ways a stop order can be used to give you more control over what happens in your investment account. The different types of stop-losses include:
Sell Stop Order
Sell stop orders are designed to limit losses for investors who have long positions, meaning they own shares and believe the price of the stock will increase. Of course, if the price of a stock you own drops, you’ll realize losses — losses which the sell stop order is designed to limit.
With sell-stop orders, once the price of the stock falls to a predetermined level, an order is placed to sell shares, stopping your losses at that point.
For example, let’s say you purchased ABC stock at $10 per share and set a stop-loss at $9 per share. This would limit your losses on the trade to 10% plus the cost of the trade itself, even if the price continues to fall further. As soon as the stock price drops to or below $9 per share, your position in the stock will be liquidated.
As a result, you have unlimited potential for upward movement if the price increases the way you hope it will, but a limited potential for losses if it drops.
Buy Stop Order
A buy stop order is a type of stop-loss that’s commonly used by short sellers. These investors borrow shares from long-term investors and sell them immediately in the open market, hoping that the share price will fall. Once the price falls, the owner of the short position repurchases the borrowed shares to return them to the original owner, making a profit in the process.
As with any investment, short positions can go the wrong way. If the share price increases above the price at which the investor sold the borrowed shares, the difference between the repurchase price and the sell price becomes a loss for a short seller.
Buy stop orders are a form of stop-loss designed to limit these losses when stocks are shorted. In this case, once the share price hits the stop price, new shares of the stock are purchased at the next available price, limiting the losses the investor realizes during the trade.
For example, let’s say you shorted ABC stock, selling 100 shares into the open market at $10 per share and setting a stop-loss at $11 per share. This limits the potential for losses to 10% plus the cost of the trade, even if the price of ABC stock unexpectedly soars. After all, if the price of the stock rises to $11 per share, you’ll automatically purchase new shares to cover your short position, limiting your losses to $1 per share plus the cost of the trade.
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Advantages of Stop-Loss Orders
There are three key advantages to taking advantage of stop-loss orders. They include:
1. The Ability to Limit Losses
Investing is ultimately an attempt to predict the future. When you make an investment, you’re betting the asset you purchase will be worth more money in the future than it is today.
That’s not always how it plays out.
Volatility is commonplace in the market, making it difficult to determine the best time to buy or sell and often leading investors to lose money. Taking advantage of a stop-loss limits your losses in the event your trade goes the wrong way.
The simple fact is that if you decide to invest, there will be times when you’ll be forced to level with losses. The ability to limit these losses makes it easier to pick yourself up, brush your shoulders off, and continue moving forward on the path toward financial stability.
2. The Ability to Lock in Profits
While stop-loss orders are designed to limit the losses you experience as you invest, they can also be used to lock in profits. Oftentimes, investors will use a stop-loss on an investment that is already profitable, locking in the profits and leaving room for more movement to the upside.
For example, let’s say you purchased ABC when the stock’s price was $10 per share. When you open your trading account, you see the current market price of ABC is now $10.75 per share. Congratulations, you’ve made a smooth 7.5% profit on the trade so far!
But what if you’re not willing to end the trade because you believe there’s still plenty of room in the upward direction? It would be a shame to let these profits slip away as quickly as they came if the price reverses, but it would also be rough to sell your shares only to watch them continue to climb ever higher and higher.
In this case, you could decide to put a stop-loss on the trade at $10.50. If the price of ABC falls to $10.50 or below, your shares will be sold, locking in profits of $0.50 per share, or 5%. However, if the stock continues upward, the sky’s the limit with regard to how big your profits might become. In this case, the stop-loss is used to guarantee a win-win outcome.
3. A Way to Limit Emotional Trading
Emotion is the enemy of the stock market investor. Fear and greed often drive the decisions of newcomers, resulting in bad decisions and mounting losses. However, when a stop-loss order is placed, it eliminates the danger of much of the emotion.
One of the biggest emotions that arises in investing — the fear of loss — leads to more losses than you could imagine.
Think about it this way: say you purchase ABC stock at $10 per share. When it falls to $9 per share, your strategy says you should sell it, but you’re afraid to accept the loss and decide to wait for the stock to bounce back. The next week, you log into your trading account to find that ABC had fallen to $7 per share, now multiplying your losses by three.
If you had used a stop-loss order from the start, your strategy would have been followed to the letter automatically, resulting in your losses being limited to 10% plus the cost of the trade.
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Disadvantages of Stop-Loss Orders
While there are plenty of reasons stop-loss orders should be part of your trading strategy, there are some drawbacks to the concept that should be considered. The most significant of these include:
1. Potentially Unnecessary Sales
The stock market is known for price movements on a short-term basis. The idea is that by buying and holding stocks for the long term, the ebbs and flows will work themselves out, resulting in long-term gains over time.
Sometimes the short-term declines can be larger than originally anticipated, but then a recovery takes place, turning losses into profits. In these cases, stop-loss orders placed too aggressively will result in unnecessary sales of stocks that you intended to buy and hold.
In some cases, the purchase price to repurchase the shares you sold under the stop-loss could be higher than the price at which the shares were sold, leading to losses if you try to buy back in.
As a result, it’s important to choose your stop-loss prices carefully, setting them at the absolute maximum you’d be willing to lose on a given trade to avoid hiccups like this in your portfolio.
2. They Only Protect You So Much
It’s also important to consider the fact that stop-loss orders will only protect you so much. Oftentimes, when newcomers hear about the stop-loss, they make investments without adequate research under the idea that they can only lose so much, so what’s the risk?
No matter what systems you’ve set in place to protect you from losses, they can still happen. It’s important not to let your guard down when making investment decisions as a result of a false sense of security offered through a stop-loss.
After all, if an asset is too thinly traded, there may be no buyers for your shares, and you’ll be stuck holding the bag. Moreover, large gaps between the closing prices and the opening prices of stocks take place often, but stop-loss orders will only be executed once the market opens. As a result, your shares may sell for far less than you expected.
Stop-loss orders are important tools that should be used by just about every investor or trader out there. These tools not only have the ability to act as an insurance policy, limiting your losses when things go wrong, but they also act as a way to lock in your profits, giving you a way to have your cake and eat it too.
Nonetheless, while stop-losses should be taken advantage of, it’s important not to allow them to give you a false sense of security. They are a valuable tool to help you stick to your trading strategy, but they don’t give you 100% protection against your investments going wrong.
That’s why it’s important to do your research before diving into any investment. An educated investment decision is the most likely to be a successful one.