Stop-Loss

Also known as a stop order, a stop-loss is one of the trade order types.

What Is a Stop-Loss?

It is an order to buy or sell a stock when the price of the stock reaches a certain limit - the stop price. After that, it becomes a market order. Stop-Loss is commonly used for stocks and futures that trade on an exchange.

When it becomes a market order, it means that the trade will definitely be executed, but not necessarily at or near the SP. It typically happens in the case of insufficient liquidity as compared with the order size or the order is placed into a fast-moving market.

Types of Stop Orders

There are the following types:

• Buy Stop Order. An instruction to buy a stock when it exceeds the current market price. It is typically used to limit a loss or protect an existing profit on a short sale. A buy always exceeds the current market price. For example, you short sell a stock hoping for the stock price to go down so you can return the borrowed shares at a lower cost. In this case, you may use it to hedge against losses if the stock goes too high.

• Sell Stop Order. An instruction to sell at the best available price after it goes below. A sell is always lower than the current market price. For example, if you hold a stock that is currently valued at $40 and is worried that the value may drop, you can place an order at $30. If the stock drops to $30, the broker will sell it at the next available price. If the SP equals or exceeds the purchase price, this can limit your losses or lock in some of your profits.

• Trailing. This type is entered with a stop parameter that creates a moving (trailing) activation price. This parameter is entered as a percentage change or actual specific amount of rise or fall in stock. Trailing stop sell orders are used to protect the profit as the stock price goes up and limit losses when it goes down.

• Stop limit order. An instruction to buy or sell a stock that combines the features of a stop order and a limit order. It includes two prices: a stop and a limit price. You can use this order type to activate a LO when a specific SP has been met. For example, if you purchase shares at $50 and expect the stock to rise, you can place an SLO to sell the shares if it does not happen. If you set the SP at $30 and the LP at $31, the order will be activated if the stock trades at $30 or lower. If the stock drops overnight to $29 per share, then the order will be activated, but it will not be executed immediately if there are no buyers at the set LP of $31 per share. It is also possible to set the same stop and limit prices.

Why Stop-Loss Orders Matter?

Such orders help eliminate emotions that can impact trading decisions, especially when you are not able to watch the position. Future prices are unknown to the market and every trade entered implies a risk. It can minimize such risks.

Summary

A stop order is an instruction to buy or sell a stock when the price of the stock reaches a specified limit, which is known as the stop price, and then the stop order becomes a market order. The types are the buy, sell, trailing, and stop limit order. A stop order can mitigate the risks related to unpredictable price movements and thus help avoid losses.