What Is a Stop Loss Order?
A stop loss is a type of order wherein a market buy or sell order is executed automatically if the asset reaches a specific price. This allows traders to manage risk without monitoring the market around the clock.
Stop losses can be used to minimize losses and/or lock in profits of an existing position. Thus, it is highly recommended for novice traders to learn both their concept and their usage. Yet, they are an important weapon in any trader’s arsenal.
As one of the most commonly used position management tools, most modern trading accounts come equipped with them.
While not perfect, they can be an absolute life (or profit) saver.
How Stop Losses Work
Practically speaking, stop-losses are quite simple.
Just like the name implies, they are predominately used to stop losses.
For instance:
- You buy a stock priced at $10.00 based on a signal that a 10% bullish move may be imminent, which would take the stock to $11.00.
- Based on your strategy, a 2% downward move means that the signal has failed and you should exit the trade.
- You set a stop loss at $9.80, 2% below your entry price. If the stock falls down to this trigger price, known as the “stop price,” your position will be exited automatically. This way, you are protected against additional losses.
The above example illustrates a basic stop-loss strategy on a simple long position. It is also possible to place stop-loss orders on simple short positions as well.
However, stop-loss execution can be more nuanced and pose certain issues.
Stop-Loss vs Stop-Limit
Stop-limit orders are similar to stop-losses, with key differences.
Stop-losses initiate a market order when the stop is triggered.
Stop-limits initiate a limit order when the stop is triggered and therefore require you to set a limit price as well.
Each of these stop order types has its own pros and cons.
Stop losses exit your position at the current market price. This means that your position is sold immediately on the spot market. They are quick and straightforward. Unfortunately though, certain complications could lead to less-than-ideal exits. For example, gap opens could trigger your stop loss and lead to greater losses than you may have taken with a stop-limit or manual exit.
Stop limits exit your position at the limit price you set. This means that you set the price at which your position is sold after the stop is triggered. Once your stop price is hit, your position is placed on the market as a limit order. This allows you to fine-tune your exit price but you run the risk of the order failing to execute.
Ultimately, how you manage your positions comes down to your trading strategy and corresponding risk tolerance.
Only you can determine whether a stop-loss or stop-limit is right for you.