Stop-loss orders: Managing your risks

What Is a Stop-Loss Order?

A stop-loss order is a tool used by traders to limit potential losses or lock in profits on an existing position. By using a stop-loss order, traders can manage their risk exposure.

A stop-loss order instructs to close out a position by buying or selling a security at the market when it reaches a specified price, known as the stop price.

This is different from a stop-limit order, which specifies a price at which to buy or sell once the security reaches the stop price. While stop-limit orders may not always be executed, a stop-loss order will always be executed if there are buyers and sellers for the security.

For example, if a trader buys a stock and sets a stop-loss order with a stop price 10% below the purchase price, the order will trigger if the stock drops to that level, and the stock will be sold at the best available price.

Although commonly associated with long positions, stop-loss orders can also protect short positions. In such cases, the position is closed out through an offsetting purchase if the security trades at or above a specific price.

How Stop-Loss Orders Work

Traders and investors use stop-loss orders to limit losses and protect profits. By setting a stop-loss order, they manage risk by exiting a position if the security's price moves against their position.

A stop-loss order to sell directs a broker to sell a security if its market price falls to or below a specified stop price. Conversely, 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 turns into a market order to be executed at the best available price once the security reaches the stop price. In contrast, a stop-limit order triggers at the stop price but may not be executed if it cannot be fulfilled at the specified limit price. This means a stop-loss order removes the risk of a position not being closed out as the stock price continues to fall.

Potential Disadvantages

One disadvantage of a stop-loss order is the potential for price gaps. If a stock's price suddenly gaps below (or above) the stop price, the order would trigger and execute at the next available price, even if it's far from your stop-loss level.

Another drawback is getting stopped out in a volatile market that quickly reverses and resumes in a direction beneficial to your position.

Investors can add flexibility to a stop-loss order by using a trailing stop. A trailing stop sets the stop price at a certain percentage or dollar amount below (or above) the current market price, moving up with the security's price to lock in profit while protecting from downside risk.

Some traders and investors also use option contracts instead of stop orders to better control their exit price points.

Benefits of Stop-Loss Orders

• Stop-loss orders provide an effective and simple method to manage trading risks.
• They help traders secure profits.
• Any investor can incorporate them into their investment strategy.
• They instill discipline in short-term trading practices.
• They remove emotional decision-making from trading.
• They reduce the necessity for constant monitoring of investments.

Examples of Stop-Loss Orders

1. A trader buys 100 shares of XYZ Company at $100 and sets a stop-loss order at $90. Over the next few weeks, the stock declines and falls below $90. The stop-loss order is triggered, and the position is sold at $89.95, resulting in a minor loss. The market continues to trend downward.

2. A trader buys 500 shares of ABC Corporation at $100 and sets a stop-loss order at $90. After the market closes, the company reports unfavorable earnings. When the market reopens, ABC's stock price gaps down. The stop-loss order is triggered and executed at $70.00, resulting in a substantial loss. However, as the market continues to drop, closing at $49.50, the stop-loss order still limits the loss compared to what it could have been.

How Does a Stop-Loss Order Limit Loss?

A stop-loss order limits your potential losses by automatically closing out your position if the stock's price reaches an unfavorable level you set. Using a trailing stop with your stop-loss order provides additional protection, as it adjusts with your position's increasing value. This means that instead of a complete loss, you might only see a reduction in profit.

Do Long-Term Investors Need Stop-Loss Orders?

Probably not. Long-term investors typically don't need to worry about market fluctuations since they can wait for the market to recover from downturns. However, they should still evaluate market drops to decide if any action is necessary. For instance, a downturn might be a good opportunity to add to their positions rather than exiting them.