Understanding Stop-Loss Orders

Understanding Stop-Loss Orders

Stop-loss orders are placed with brokers to automatically buy or sell assets once they reach a certain price. Find out how you can use them to mitigate risk.
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Beginner
4 min read
Written by: Harry Atkins
November 30, 2019
Updated: February 24, 2021

Stock trading can be a lucrative venture when trades move in the direction you expect. But what happens when a stock’s price moves in the opposite direction? You could lose any profits made, and much of the capital that you have invested too. As such, there is a need for what is known as a stop-loss order to protect your capital from unfavourable price movements.

I. What is a stop-loss order?

Given the highly volatile nature of the securities market, trade positions can become unprofitable. Such positions might result in loss of capital; in extreme cases, those losses can discourage would-be investors from future trades. The way to get around this is by setting a stop price. This is simply the threshold over which a position automatically becomes a market order. This order to convert a position into a market order is what constitutes a stop-loss order.

A stop-loss order can be either buy or sell

A sell stop order sets a kind of floor for the price of the security. If the price hits that floor and goes past it, the position automatically triggers a market order. In simple terms, if your stock goes below a certain price, your broker will sell it immediately to protect your financial position. 

On the other hand, the buy stop order sets a ceiling in that a trader locks in profits before the stock takes a turn for the loss. In simple terms, if your stock reaches a certain value, your broker will try and sell it immediately to lock in your win.

For example, consider a trader who owns a certain amount of shares belonging to company WXY. To protect the position from loss, the trader sets $20 as the sell stop order. If the price of WXY’s stock reaches $20, the position threatens to become unprofitable, and it automatically becomes a market order.

However, this works differently for a profitable position. Say the trader sets $50 as the buy stop order. Specifically, the trader intends to take a profit once the price of WXY’s stock hits $50. As such, the trader will enjoy profits in case the price turns on its head and slides to under $50.

These are vital trades that help you maneuver the stock market, if you can’t monitor the stock market 24 hours per day, then you need to have these in place.

II. Types of stop-loss orders

There different kinds of stop-loss orders available to traders. These are:

  • Regular stop order – This is an order that instructs the broker to execute a market order the moment it hits a certain stop price. However, a fast-moving market might not allow the execution to happen at the stop price. As such, the trader is at risk of suffering substantial slippage.
  • Stop limit order – This is a sophisticated form of stop-loss order that aims to cure the problems of the regular stop-loss order. This order entails the trader setting two stop prices, one for stop order and the other for limit order. While there is a guarantee of order execution with a regular stop order, the process might execute at a far worse price than desired. As such, the limit order offers insurance against such an occurrence since it guarantees a price limit.
  • Trailing stop order – Here, the trader does not set a specific stop price. Instead, he/she relies on the percentage change in the prevailing market price. If the market price declines below a certain target percentage, the position automatically converts to a market order. This is preferred by those who are simply looking to avoid volatility.

Bottom line

A stop-loss order is an insurance scheme for securities traders. It protects the positions of investors who trade in highly liquid markets where prices can change direction quickly.

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