What Is a Stop-Loss Order and How Does It Work?
What is a Stop-loss ? A stop-loss order is a purchase or sale order made with a broker when the price of a security reaches a certain level. Stop-loss orders are different from stop-limit orders in that they are designed to limit an investor’s loss on a position in a security. When a stock falls below the stop price, the order transforms into a market order, which executes at the best available price. A trader may, for example, purchase a stock and place a stop-loss order 10% below the purchase price. If the stock falls below a certain level, the stop-loss order will be activated, and the shares will be sold as a market order.
Although most investors identify a stop-loss order with a long position, it can also be used to safeguard a short position, in which the security is purchased if it trades over a set price.
A stop-loss order instructs you to buy or sell a stock when it hits a specific price, known as the stop price.
When the stop price is reached, the stop order transforms into a market order, which is executed at the next available opportunity.
Protection
Traders or investors can use a stop-loss order to protect their winnings. Since it becomes a market order, it eliminates the possibility of an order not being executed if the stock continues to fall. A stop-limit order is triggered when the price goes below the stop price; however, due to the value of the limit element of the order, the order may not be executed.
Disadvantages
The only disadvantage of using a stop-loss is if a stock unexpectedly drops below the stop price. Even if the stock is trading severely below your stop-loss threshold, the order will trigger, and the stock will be sold at the next available price.
Brokers
When a consumer requests that a broker sell a security if it falls below a set stop price, this is known as a sell stop order. The stop price in a buy stop order is set higher than the current market price.
Combining a stop-loss order with a trailing stop can improve the effectiveness of a stop-loss order. A trailing stop is a trading order in which the stop-loss price is placed at a percentage or dollar amount below the market price rather than a fixed dollar amount.
An example of a Stop-Loss Order
A trader pays $100 for 100 shares of XYZ and places a stop-loss order at $90. Over the following two weeks, the stock will go below $90. The trader’s stop order is filled, and the position is sold for $89.95.
A trader pays $100 for 500 shares of XYZ and places a new stop-loss order at $90. This time, the company’s profits were dismal, and the stock dropped by more than 50%. The trader’s stop order is triggered when the market reopens, and the trade is executed at $49.50.
Moving stop loss orders
Many traders continue to move their stop-loss orders while the trade is in a positive position. If you have bought the shares and the market goes up, it is then possible to move your stop-loss order up to a break-even position in order to minimise your exposure.
