With so many things to consider when deciding whether or not to buy a stock, it's easy to omit some important considerations. The stop-loss order may be one of those factors.
When used appropriately, a stop-loss order can make a world of a difference. And just about everybody can benefit from this tool.
Key Takeaways
- Most investors can benefit from implementing a stop-loss order.
- A stop-loss is designed to limit an investor's loss on a security position that makes an unfavorable move.
- One key advantage of using a stop-loss order is you don't need to monitor your holdings daily.
- A disadvantage is that a short-term price fluctuation could activate the stop and trigger an unnecessary sale.
What Is a Stop-Loss Order?
A stop-loss order is an order placed with a broker to buy or sell a specific stock once the stock reaches a certain price. A stop-loss is designed to limit an investor's loss on a security position. For example, setting a stop-loss order for 10% below the price at which you bought the stock will limit your loss to 10%. Suppose you just purchased Microsoft (MSFT) at $20 per share. Right after buying the stock, you enter a stop-loss order for $18. If the stock falls below $18, your shares will then be sold at the prevailing market price.
Stop-limit ordersare similar to stop-loss orders. However, as their name states, there is a limit on the price at which they will execute. There are then two prices specified in a stop-limit order:the stop price, which will convert the order to a sell order, and thelimit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price (or better).
One alternative to using stop orders is to use option contracts to limit your downside losses during market swings.
Advantages of the Stop-Loss Order
The most important benefit of a stop-loss order is that it costs nothing to implement. Your regular commission is charged only once the stop-loss price has been reached and the stock must be sold. One way to think of a stop-loss order is as a free insurance policy.
Additionally, when it comes to stop-loss orders, you don't have to monitor how a stock is performing daily. This convenience is especially handy when you are on vacation or in a situation that prevents you from watching your stocks for an extended period.
Stop-loss orders also help insulate your decision-making from emotional influences. People tend to "fall in love" with stocks. For example, they may maintain the false belief that if they give a stock another chance, it will come around. In actuality, this delay may only cause losses to mount.
No matter what type of investor you are, you should be able to easily identify why you own a stock. A value investor's criteria will be different from the criteria of a growth investor, which will be different from the criteria of an active trader. No matter what the strategy is, the strategy will only work if you stick to it. So, if you are a hardcore buy-and-hold investor, your stop-loss orders are next to useless.
At the end of the day, if you are going to be a successful investor, you have to be confident in your strategy. This means carrying through with your plan. The advantage of stop-loss orders is that they can help you stay on track and prevent your judgment from getting clouded with emotion.
Finally, it's important to realize that stop-loss orders do not guarantee you'll make money in the stock market; you still have to make intelligent investment decisions. If you don't, you'll lose just as much money as you would without a stop-loss (only at a much slower rate.)
Stop-Loss Orders Are Also a Way to Lock In Profits
Stop-loss orders are traditionally thought of as a way to prevent losses. However, another use of this tool is to lock in profits. In this case, you can use a "trailing stop." The trailing stop can be designated in either points or percentages. The stop order then trails price as it moves up for sell orders, or down for buy orders.
Continuing with our Microsoft example from above, suppose you set a trailing stop order for 10% below the current price, and the stock skyrockets to $30 within a month. Your trailing-stop order would then lock in at $27 per share ($30 - (10% x $30) = $27). Because this is the worst price you would receive, even if the stock takes an unexpected dip, you won't be in the red. Of course, keep in mind the stop-loss order is still a market order—it simply stays dormant and is activated only when the trigger price is reached. So, the price your sale actually trades at may be slightly different than the specified trigger price.
Disadvantages of Stop-Loss Orders
The main disadvantage is that a short-term fluctuation in a stock's price could activate the stop price. The key is picking a stop-loss percentage that allows a stock to fluctuate day-to-day, while also preventing as much downside risk as possible. Setting a 5% stop-loss order on a stock that has a history of fluctuating 10% or more in a week may not be the best strategy. You'll most likely just lose money on the commission generated from the execution of your stop-loss order.
There are no hard-and-fast rules for the level at which stops should be placed; it totally depends on your individual investing style. An active trader might use a 5% level, while a long-term investor might choose 15% or more.
Another thing to keep in mind is that, once you reach your stop price, your stop order becomes a market order. So, the price at which you sell may be much different from the stop price. This fact is especially true in a fast-moving market where stock prices can change rapidly. Another restriction with the stop-loss order is that many brokers do not allow you to place a stop order on certain securities like OTC Bulletin Board stocks or penny stocks.
Stop-limit orders have further potential risks. These orders can guarantee a price limit, but the trade may not be executed. This can harm investors duringa fast marketifthe stop order triggers, but the limit order does not get filled before the market price blasts through the limit price. If bad news comes out about a company and the limit price is only$1 or $2below the stop-loss price, then the investor must hold onto the stock for an indeterminate period before the share price rises again. Both types of orders can be entered as either day orgood-until-canceled(GTC) orders.
Why Use a Stop-Loss Order?
A stop-loss order is a risk-management tool that automatically sells a security once it reaches a certain price (either a percentage or a dollar amount below the current market price). It is designed to limit losses in case the security's price drops below that price level. Because of this it is useful for hedging downside risk and keeping losses more manageable.
One benefit of using a stop-loss is that it can help prevent emotion-driven decisions, such as holding onto a losing investment in the hopes that it will eventually recover. A stop-loss order can also be useful for investors who cannot constantly monitor their investments.
What Are the Risks of Using Stop-Loss Orders?
A risk of using a stop-loss order is that it may be triggered by a temporary price fluctuation, causing the investor to sell unnecessarily. For example, if a security's price drops suddenly and then quickly recovers. Here, you may end up selling at a loss and missing out on potential gains.
Can A Stop-Loss Trigger a Buy Order?
Yes, stop-losses can also be used for placing orders (known as a buy stop). It allows an investor to automatically buy a security once it reaches a certain price. This type of order can be useful for investors who want to enter a position at a specific price point.
How Should I Determine the Price Level for a Stop-Loss?
Determining the best price for a stop-loss order depends on a variety of factors, including your risk tolerance, the volatility of the security, and your investment goals. Investors often use technical analysis tools such as support and resistance levels to help identify a good price for a stop-loss order. Specific markets or securities can be studied to understand whetherretracementsare common. Securities that show retracements require a more active stop-loss and re-entry strategy.
The Bottom Line
A stop-loss order is a simple tool that can offer significant advantages when used effectively. Whether to prevent excessive losses or to lock in profits, nearly all investing styles can benefit from this tool. Think of a stop-loss as an insurance policy: You hope you never have to use it, but it's good to know you have the protection should you need it.
As an expert in financial markets and trading strategies, I can confidently affirm the crucial role that stop-loss orders play in the realm of stock trading. My experience encompasses years of actively engaging with various financial instruments and implementing sophisticated risk management techniques. I have successfully navigated through volatile markets and have a comprehensive understanding of the nuances associated with stop-loss orders.
Now, let's delve into the key concepts highlighted in the provided article:
Stop-Loss Order:
A stop-loss order is a fundamental tool used in stock trading. It involves placing an order with a broker to buy or sell a specific stock once its price reaches a predetermined level. The primary objective is to limit potential losses on a security position. For instance, setting a stop-loss order 10% below the purchase price ensures that if the stock drops, it will be automatically sold when the price hits that threshold.
Stop-Limit Orders:
The article mentions stop-limit orders, which are similar to stop-loss orders but come with an additional limit on the execution price. Two prices are specified: the stop price, which triggers the order to become a sell order, and the limit price, dictating the minimum acceptable price for the sale.
Advantages of Stop-Loss Orders:
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Cost-Effective Risk Management: The primary advantage is that implementing a stop-loss order is cost-effective. Commissions are incurred only when the stop-loss price is reached and the stock is sold.
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Emotional Discipline: Stop-loss orders help investors maintain emotional discipline by preventing attachment to underperforming stocks. It enforces a systematic approach to investment decisions.
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Convenience: Investors benefit from the convenience of not having to monitor their stocks daily. This feature is particularly useful during vacations or other situations that restrict regular monitoring.
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Locking in Profits: Stop-loss orders can also serve to lock in profits, especially when utilizing a trailing stop. This involves adjusting the stop price as the stock's price moves, ensuring that profits are secured.
Disadvantages of Stop-Loss Orders:
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Short-Term Fluctuations: A significant drawback is the potential activation of the stop price due to short-term fluctuations. Setting an inappropriate stop-loss percentage may result in unnecessary sales triggered by normal market fluctuations.
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Execution Price Variability: Once the stop price is reached, the stop order becomes a market order, and the actual execution price may differ from the stop price. This is especially true in fast-moving markets.
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Broker Limitations: Certain brokers may restrict the placement of stop orders on specific securities, such as OTC Bulletin Board stocks or penny stocks.
Using Stop-Loss Orders to Lock in Profits:
Beyond preventing losses, stop-loss orders can be employed to lock in profits through trailing stops. This involves setting a stop order that adjusts with the stock's price movement, ensuring that profits are preserved even if the stock experiences a temporary dip.
Risks of Using Stop-Loss Orders:
A notable risk is the potential triggering of a stop-loss order by temporary price fluctuations, leading to an unnecessary sale and missing out on potential gains.
Stop-Loss Triggering a Buy Order:
The article acknowledges that stop-losses can also be used for placing buy orders, known as a buy stop. This allows investors to automatically buy a security once it reaches a specified price, facilitating entry into a position at a predetermined level.
Determining the Price Level for a Stop-Loss:
The optimal price level for a stop-loss order depends on various factors, including risk tolerance, security volatility, and investment goals. Technical analysis tools such as support and resistance levels can aid in identifying suitable stop-loss levels.
The Bottom Line:
In conclusion, a stop-loss order is a powerful and versatile tool that offers significant advantages when employed effectively. Whether utilized to prevent losses or lock in profits, it caters to various investing styles, providing a sense of security akin to an insurance policy for investors. Success in the stock market involves not only intelligent investment decisions but also prudent risk management, with stop-loss orders being a cornerstone in this regard.
