What is a stop-loss order?

In a nutshell

A stop-loss order is an investment tool that allows investors to sell a stock at a predetermined price level.

• Stop loss orders let investors determine how much they’re prepared to lose on a security position at the time of purchase, or any time thereafter.
• Investors can set a floor on a stock price, at which point the sale will take place automatically, therefore limiting the risk of a deep plunge in the stock price.
• A stop-loss order is optional, but it can be a valuable tool when used to limit investment risk.

How does a stop-loss order work?

You’ll need to have an account with an investment broker, and this account must have the option of self-directed trading of individual stocks and the ability to set stops and other order types.

Most trades are executed at the market. This means the buyer or seller agrees to execute the transaction at the current price. However, there are a series of order types that enable the investor to decide the price at which a security will be bought or sold in advance. A stop-loss order is one of them.

You can set a stop-loss order on nearly any security, which can be done immediately after purchase or any time thereafter. A stop-loss order functions as a brake on the potential decline of a security’s price.

Stop-loss order example

Let’s say you own 120 shares of Intel, and it is currently trading at $42.73 per share. You decide to set a stop-loss on the stock at $38 per share. (This is a drop of slightly more than 10%).

After setting up the trade, you’ll need to indicate “Stop” in the “Order type” field. Then, In the box to the right of “Order type,” you’ll enter the Stop price of $38 per share.

The next field you’ll need to complete is “Timing.” This is where you’ll indicate if you are setting the stop for just a single day so it will expire at the end of the trading day or “good till canceled” (GTC). GTC sets up a stop as an open order. Depending on the broker, the GTC may be good for 120 days, 180 days, or some other time limit. This means the stop order will be executed at the desired price if it’s reached at any time during that time frame. If you reach the end of the stated time frame and still own the stock, you can extend the GTC order.

Once the stop has been set, there’s nothing more you have to do. The sale will automatically trigger if the stock price falls to $38 per share. If it never drops that low, the sale will not take place. However, the stop-loss order will have done its job by protecting you from an unexpected plunge in the price of the stock.

Types of stop-loss orders

There are three types of stop-loss orders:

Stop order

This is the most basic type of stop-loss order. It’s an order that, once put in place, will initiate the sale of the stock owned once it reaches a certain price level set by the investor. However, the desired price level serves only as a trigger. Once that price has been reached, the sale will be automatic, but the price itself is not guaranteed.

For example, if a stop is set at $40 per share, the broker will begin selling your position. It is possible, however, that the stock will be sold at less than $40. This can happen when the price of a stock is falling rapidly and quickly falls below the stop price.

Stop limit

This type of order works similarly to a basic stop-loss order, except it establishes a price limit at which the stock is to be sold. For example, if the stop limit is set at $40, the stock will only sell at $40 or above. If the stock drops to $35 — perhaps due to negative overnight news — the order will not be executed unless the stock price returns to $40.

Trailing stop

A trailing stop can be thought of as a flexible stop-loss order. That’s because the stock price is determined by a percentage of the share price, rather than a specific predetermined price. This type of stop-loss order is good to use when you own a stock that has risen significantly in value, and you want to lock in those gains.

For example, let’s say you’ve purchased a stock at $50, but it has since risen to $80. To lock in your gains in the event of a price reversal, you set a trailing stop at 10%. A stop-loss order will be triggered if the share price falls to $72 ($80 X .90). If the price of the stock continues increasing to $100, the new stop-loss price will be $90.

Stop-loss orders pros and cons

How to set stop loss levels

Setting stop-loss levels isn’t as simple as picking a certain percentage loss you’re willing to accept and employing it across all your investments. Where you set a stop-loss depends on different factors, including the purpose for holding the stock in the first place and the characteristics of the stock itself. Here are some factors to consider.

Holding period

Do you intend the stock to be a long-term holding (one year or more) or a short-term trade? If you plan the investment to be long-term, you may either forgo setting a stop-loss, or you may choose to set a more generous one, such as 20%. If it’s a short-term trade, you might decide you don’t want to lose any more than 5%.

Your risk tolerance

If you are a more conservative investor, your stress level is likely to rise with smaller losses (versus if you are a more aggressive investor). You may decide you’re not going to lose any more than 10% on any stock. If you are more aggressive, 15% to 20% may be fine.

Price volatility

Price volatility relates to the stock itself. Some stocks are more steady, moving in predictable patterns. Others, like technology stocks, are highly volatile. If a stock is stable, setting a stop-loss at 5% or 10% may be reasonable. But with a more volatile stock, something closer to 20% may be a better strategy to avoid stopping out on your positions too frequently.

Stock liquidity

Stop-loss orders are most effective on large, widely-held stocks. This is because it’s more likely you will get your chosen stock price if there are always plenty of buyers for that security. If, however, you’re holding a small-cap stock (one that trades only a few thousand shares a day) the stock price could drop well below your price before the broker can find a buyer to purchase it.

Number of shares owned

It’s much easier to work a stop-loss order when you own a few hundred shares. If you own several thousand, particularly of a thinly traded stock, you’ll likely exit the position at multiple price levels. In this type of scenario, a stop-loss may be ineffective.

Price action

If you own a stock that has risen sharply in value, you may want to set lower stop levels. For example, if you purchase a stock for $20 a share, and it rises to $40, a 10% stop-loss will preserve more of your gain than a 20% stop.

The AP Buyline roundup

As you can see, a stop-loss is a valuable tool that can be used to minimize risk in an investment portfolio. Ironically, it’s a risk management tool that is not itself without any risk.

By its very nature, the stock market is volatile. Prices rise and fall, and then rise again. When you set a stop-loss on a stock, the stock will automatically be sold, and you will not participate in the price rebound. For that reason, it’s probably a better tool for short-term traders than long-term, buy-and-hold investors. As a long-term investor, price swings are all part of the game. But if you stop out any time there’s a short-term loss, you can miss out on long-term gains.

Before employing this strategy across the board, start by testing a small stock position in your portfolio. This will allow you to see exactly how the process works, and you’ll be in a better position to know if it will work for you on other stock holdings.