Brokerages execute a variety of stock order types for investors to buy and sell stocks. Most of these order types indicate to the broker an investor's preference to purchase or sell a stock at a desired (or better) price. Other order types enable investors to reduce their risk of losses on trades. A stop-loss order is a type of stock order that enables an investor to limit the potential loss on a stock position by setting a price limit that triggers the stock's trade.
Image source: The Motley Fool
A stop-loss order triggers the sale of a stock (or a purchase for investors buying to cover a short position) once the stock's price reaches a certain value. Investors create stop-loss orders to automatically sell stocks (or cover short positions) once the stock's price reaches the trigger price set by the stop-loss order.
Example
Stop-loss order example
Investors often use stop-loss orders to limit their losses on new positions. Let's say an investor purchases 100 shares of a hot new tech stock of a company that recently completed its initial public offering (IPO) at $25 per share. To limit the potential loss on this stock purchase, the investor sets a stop-loss order at 20% below the purchase price, which equals $20 per share.
If the price of the red-hot tech stock declines to $20, then that triggers the investor's stop-loss order. The investor's broker proceeds to sell the stock at the prevailing market price, which may be exactly at the $20 trigger price but can be much lower, depending on the the nature and timing of the stock's price movements.
Advantages
Advantages of the stop-loss order
Investors use stop-loss orders as part of disciplined strategies to exit stock positions if they don't perform as expected. Stop-loss orders enable investors to make pre-determined decisions to sell, which helps them avoid letting their emotions influence their investment decisions.
Other advantages of a stop-loss order include:
- Brokers don't charge for setting up stop-loss orders (although some still charge commissions on the actual trades), making them essentially a no-cost insurance policy to limit losses on investments.
- Routine use of stop-loss orders helps investors become more disciplined about selling losing stocks.
Disadvantages
Disadvantages of the stop-loss order
There are disadvantages to using stop-loss orders. First, establishing a stop-loss order doesn't limit an investor's loss to the difference between the purchase price and the pre-determined sale price. If a company reports disappointing earnings after the market closes, for example, then its share price by the start of the next trading day could be well below an investor's stop-loss price.
Another potential pitfall of stop-loss orders is that they can trigger a stock sale even if the stock's price dips only slightly below the trigger price before quickly recovering. If a stock's price is volatile or another event occurs that causes a brief sell-off by other investors, that can trigger an investor's stop-loss order.
Finally, during sharp market declines, sophisticated investors like hedge fund operators sometimes try to take advantage of the existence of stop-loss orders. Known as "stop hunting," traders short stocks already in decline in order to push prices lower in an attempt to trigger a flood of stop-loss orders. These investors subsequently start buying those same stocks to profit from an expected rebound.
Why investors use them
Why do investors use stop-loss orders?
Investors primarily use stop-loss orders to limit their losses on stock positions and reduce their portfolio risks. While stop-loss orders can be useful, it's important to realize they don't always work as intended. Stop-loss orders can also lock in avoidable losses, which is why The Motley Fool favors buying and holding quality stocks to build wealth over long periods of time.
Related investing topics
The Motley Fool has a disclosure policy.
