What is a stop loss order?
It does this by triggering an exit from an investment, by selling on shares the moment they drop below a set price. But they can also be used to lock in profits when share prices increase – this is known as “trailing stop loss”.
The purpose of stop loss orders is to reduce the exposure to risk when the market works against you. It also automises trading because it automatically executes the transaction when the asset reaches a certain price.
It’s a particularly helpful strategy in scenarios where assets suddenly plummet in price. By having a stop loss order, you can exit the trade when it falls by $5, rather than when it hits its bottom and you have to sell it for $15 less than you bought it for. This will all become clearer once we take you through some examples
KEY TAKEAWAYS
- Stop losses can be used in trading in two ways: to cap the amount lost in a trade and to lock in the amount of profit made within a trade.
- Let’s say you purchase shares for $35 per share, but you decide to enter a stop loss at $30 per share. That means you automatically sell your shares at $30 per share to prevent further losses, rather than when they plummet to $20 per share. It’s a great tactic in scenarios where prices suddenly cripple in value.
- Stop-loss orders can also be used to guarantee profits once your shares reach a certain level – commonly referred to as a ‘trailing stop loss’. Let’s say you buy shares for $5 a share and you place a stop-loss order at $8 a share. When the price suddenly shoots up to $10 a share, you would lock in $3 per share profit. Although it means you don’t get the full $5 profit, the stop-loss guarantees you’ll make $3 and protects you from a situation when the price rises to $10 per share but suddenly drops to $3 (where you would lose $2 per share).
Advantages of stop loss orders
Automsied trading: A stop-loss order allows you to kick back and relax whilst your trading is automatically set up. That means you don’t have to incessantly check how your shares are performing daily and sleep easy at night!
Free to implement: It also costs nothing to implement and can therefore be seen as a free insurance policy.
Emotions are removed: By implementing stop losses, you’re less likely to make poor decisions with regards to their investments. Fear and greed (emotional investing) can be our worst enemies, so having a stop-loss order means you have a strategy and stick to it.
Disadvantages of stop loss orders
Short-term fluctuations: That being said, the disadvantage is that a stop loss is triggered, even if during a short-term fluctuation. For example, your trade might be sold the moment it drops by $2 per share, but you might lose out the minute it jumps up to $6 per share the next day. By activating the stop-loss order, the investor is unable to capture the longer term gain.
Volatile stocks: Stop losses could be particularly counter-productive when it comes to volatile stocks which are notorious for swinging in price. By activating a stop loss market order, stocks are sold the minute they reach a certain price, which could happen just days before they shoot up.
How to place a stop loss order
Placing a stop loss order is easy! Most trading platforms give you the opportunity to make one whenever a trade is placed, which you can then tweak at any time. So it’s not set in stone! They’re also free of charge to implement and the only fees incurred are when the trade is made.
Stop loss vs stop limit
Although our focus here is on stop losses, it’s important to understand it in relation to a stop limit.
The main difference is that while stop-loss orders guarantee execution when prices drop, stop-limit adds another layer to trading by determining the price an investor is willing to sell or buy an asset for in advance once it reaches the stop price. In other words, stop-limit orders allow the investor to control the price at which an order is executed once it has reached .
For an investor wanting to buy stock, setting a limit order of $50 means they automatically buy this stock as soon as the price reaches $50 or lower. For someone wanting to sell, a limit order sets the floor price. So by setting a limit order at $50, a broker is instructed to sell stocks when the price reaches $50 or more.
However, the disadvantage of a stop limit is that it incurs larger fees from stockbrokers in order to execute it. There is also no guarantee that the trade will be executed.