A Stop-Loss Order is a type of order placed with a broker to sell a security once it reaches a predetermined price. This type of order is designed to limit an investor’s potential loss on a position in a security.
- Trigger Price: The predetermined price at which the stop-loss order is activated. Once this price is reached or surpassed, the stop-loss order becomes a market order to sell the security.
- Market Order: After activation, the stop-loss order turns into a market order, which means the security will be sold at the best available price in the market.
- Stop-Limit Order: A variation of the stop-loss order, where after the stop price is reached, the trade turns into a limit order, rather than a market order. This means the security will be sold only at the limit price or better.
Benefits and Risks
- Loss Mitigation: Helps limit potential losses in volatile markets.
- Emotion Control: Provides a predefined exit point, reducing the emotional aspect of selling under pressure.
- Automatic Execution: Once set, the investor doesn’t need to constantly monitor the market. The order executes automatically when conditions are met.
- No Guaranteed Execution Price: Especially in fast-moving markets, the final executed price might be far from the initial stop price.
- Potential for Premature Sale: Short-term market fluctuations can trigger the order, potentially selling the position before a desirable price recovery.
- Order Fees: Brokers may charge fees for placing, modifying, or executing stop-loss orders.
Usage in Trading
Stop-loss orders are commonly used in both short-term trading and long-term investment strategies. They’re especially favored in volatile market conditions, helping traders adhere to predefined risk management rules and avoid large, unexpected losses. By setting a stop-loss order, traders can decide in advance the maximum amount they are willing to lose on a particular trade, making them an essential tool for many risk-conscious investors.