What is a stop loss order and how to use them?
Stop losses are crucial for risk management when trading and investing. Learn how a stop loss order works, why you should use them and how to place a stop loss trade with Stake.
What is a stop loss?
A stop loss is an order placed by an investor to sell a security if it reaches a certain price. It is used to limit potential losses by automatically triggering a sale when the price falls below a predetermined level, helping investors manage risk in their investment portfolios.
How does a stop loss work?
When an investor places a stop loss order, they specify the stop loss price at which they want their security to be sold.
For example, if an investor buys a stock at $51.50 and sets a stop loss at $50.00, they are essentially stating that they are willing to sell the stock if its price drops to $50.00 or below. The stop loss order is then communicated to their broker.
Once the stop loss order is in place, it remains dormant until the market price of the security reaches or falls below the specified stop loss price. At that point, the stop loss order is triggered, and the broker executes a market sell order to sell the security at the prevailing market price. The speed of execution depends on the liquidity and trading volume of the security.
The purpose of a stop loss is to limit potential losses. By having a predetermined exit point, investors can protect themselves from substantial declines in the value of their investments. Stop loss orders are particularly useful in volatile markets or when an investor cannot constantly monitor their portfolio. They help automate the process of risk management and can provide peace of mind to investors by reducing emotional decision-making.
What is an example of a stop loss?
Let's say an investor buys shares of a company at $100 per share and wants to set a stop loss to limit potential losses. They may decide to place a stop loss order at $90 per share. This means that if the price of the stock reaches $90 or below, the stop loss order will be triggered.
Now, if the share price falls and reaches $90, the stop loss order will automatically activate. The platform will then execute a market order, and the investor's shares will be sold at the prevailing market price, which may be slightly above or below $90.
By using a stop loss in this scenario, the investor has protected themselves from a larger potential loss. If the stock were to continue declining without a stop loss in place, the investor would have incurred a larger loss if they had sold at a lower price.
Stop loss orders are a popular risk management tool in trading and investing, as they allow investors to define their risk tolerance and protect against significant declines in the value of their investments.
Types of stop loss orders
Fixed stop loss order
One type of stop loss order is the fixed stop loss order. With a fixed stop loss order, an investor sets a specific trigger price level at which they want their security to be sold if the price reaches or falls below that level.
For example, if an investor buys a stock at $50 per share and sets a fixed stop loss order at $45, they are indicating that they want to sell the stock if the price drops to $45 or below. The fixed stop loss order remains in place until it is triggered by the market reaching or falling below the specified price.
Fixed stop loss orders provide a straightforward and clear method for managing risk. They allow investors to define their maximum acceptable loss and help protect against significant declines in the value of their investments. However, it's important to note that fixed stop loss orders do not guarantee execution at the specified price, as market conditions and liquidity can impact the actual execution price.
Trailing stop loss order
One type of stop loss order is the trailing stop loss order. Unlike a fixed stop loss order, a trailing stop loss order adjusts dynamically with the market price of the security, providing a trailing or trailing percentage-based buffer. When placing a trailing stop loss order, an investor specifies two parameters: the trailing amount or percentage and the trailing method.
As the market price of the security increases, the stop loss price adjusts upwards by the trailing amount or percentage specified. This allows the investor to lock in gains as the security's price rises while still maintaining a buffer against potential downside risk. However, if the market falls, the stop loss price remains unchanged.
If the market price reverses and falls by the trailing amount or percentage specified, the trailing stop loss order is triggered. The platform executes a market order, selling the security at the prevailing market price.
Trailing stop loss orders are beneficial for capturing profits during upward price movements while providing downside protection. They allow investors to "lock in" gains as the security's price rises while still providing a cushion against potential losses. The trailing feature automatically adjusts the stop loss level, enabling investors to potentially benefit from continued price appreciation.
Stop loss vs stop limit
There are two common types of stop loss orders: stop loss and stop limit orders.
The key distinction between a stop loss order and a stop limit order lies in the execution. A stop loss order guarantees execution, but not necessarily at the specified price. On the other hand, a stop limit order allows investors to have more control over the execution price, but there is a risk of the order not being filled if the market does not reach the specified limit price.
Investors should carefully consider their investment strategy, trading goals, market conditions, and risk tolerance when choosing between stop loss and stop limit orders, as there’s no single best alternative.
🎓 Learn about all the types of orders available on Stake.
Reasons to use a stop loss order
There are several reasons why investors may choose to use a stop loss order:
- Risk management: One of the primary purposes of a stop loss order is to manage risk. By setting a predetermined exit point, investors can limit potential losses in case the market moves against their position. It helps protect against significant declines in the value of an investment.
- Emotion control: Emotions can often cloud investment decisions, leading to impulsive actions driven by fear or greed. A stop loss order helps remove the emotional element from decision-making. Investors can rely on the predetermined stop loss level, preventing them from making rash or emotional choices during volatile market conditions.
- Time management: Monitoring investments constantly can be time-consuming. A stop loss order allows investors to set a price level and automate the sell order execution. This feature is particularly useful for busy individuals who may not have the time or availability to closely monitor their investments on a regular basis.
- Locking in profits: Stop loss orders can also be used to protect gains. If an investment has appreciated significantly, setting a trailing stop loss order can help capture profits while still allowing for potential upside. This way, investors can secure a certain level of profit while giving the investment room to continue appreciating.
- Flexibility: Stop loss orders provide flexibility in managing investments. Investors can adjust their stop loss levels based on changing market conditions, volatility, or individual investment strategies. This allows for adaptation to market dynamics and the ability to optimise risk management strategies.
It's important to note that stop loss orders have their limitations and do not guarantee protection from all potential risks, such as when the stock price suddenly gaps or slippage in fast-moving markets.
Advantages and disadvantages of a stop loss order
- Risk management: A major advantage of using a stop loss order is that it helps manage risk. By setting a stop loss price, investors can limit potential losses and protect their investments from significant declines in value.
- Less behavioural biases: Stop loss orders help remove the emotional element from trading decisions. They provide a predetermined exit point, reducing the likelihood of impulsive or emotionally-driven actions during market volatility.
- Automation: Stop loss orders can be automated, allowing for hands-off execution. Once the stop loss level is reached, the order is triggered automatically, saving time and effort for investors who may not be able to constantly monitor their investments.
- Execution variability: While stop loss orders aim to sell at or near the specified price, execution is not guaranteed at the exact stop loss level. Market conditions, liquidity, and price gaps can result in executions at slightly different prices, especially during periods of high volatility.
- False triggers: In some cases, stop loss orders can be triggered by short-term market fluctuations or intraday price volatility, resulting in premature selling. This can lead to missed opportunities if the market subsequently reverses and continues in the expected direction.
- Over-reliance: Over-reliance on stop loss orders as the sole risk management strategy may lead to a false sense of security. It's essential to consider other factors, such as fundamental analysis and market trends when making investment decisions.
What's the difference between a stop loss and limit order?
The main difference between a stop loss order and a limit order lies in their purpose and execution. A stop loss order is triggered when the market price reaches or falls below a specified stop price, and it is executed at the current market price. A limit order, on the other hand, is executed only at the specified limit price or better, and it does not have a trigger point based on the market price.
Both stop loss and limit orders are risk management tools, but they serve different purposes. Stop loss orders are used to limit losses and protect against significant declines in the value of an investment. Limit orders, on the other hand, are used to control the buying or selling price and ensure that the order is executed at a specific price or better.
Stella is a markets analyst and writer with almost a decade of investing experience. With a Masters in Accounting from the University of Sydney, she specialises in financial statement analysis and financial modelling. Previously, she worked as an equity analyst at Australian finance start-up, Simply Wall St, where she took charge of the market insights newsletter sent out to over a million subscribers. At Stake, Stella has been key to producing the weekly Wrap articles and social media content.