Investing > Stop-Loss Orders Explained

Stop-Loss Orders Explained

This guide explains everything you need to know about stop loss orders, including whether or not their benefits outweigh their disadvantages.

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Updated March 28, 2021

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The only way to win is to avoid losing.

In the markets, that means not losing money on bad trades. But how do you keep track of all your trades, and how do you catch all the best moments to buy or sell?

No need—you can automatize it will orders. 🤖

Financial advisors nowadays usually tell investors to make a conservative, low-profit portfolio. Not you don’t need to sacrifice potential returns that much—you can reach a safe portfolio with better growth potential if you set it up correctly.

A passive investing approach contradicts human behavior, particularly when markets are very alive like today, so it’s much more inspiring to get in on the action. Right?

For many investors, it is—but keep in mind that any trader worth their salt uses a stop-loss order on every single trade they make. Setting a good barricade to protect your bottom line is the most basic and crucial skill in the stock market.

Stop-loss orders are there to sell or buy assets automatically when they reach the desired price—that way, you will never pay too much or sell for too little.

In this guide, we will tell you how stop-loss orders work, why they are important, and the logic behind setting them up. That way, you will be more in control of your portfolio—and that’s the whole point of investing.

What you’ll learn
  • What is a Stop-Loss Order?
  • Advantages of Stop-Loss Orders
  • Disadvantages of Stop-Loss Orders
  • Using Stop-Loss Orders when Shorting
  • Stop-Loss vs. Stop-Limit
  • What Price Should Trigger a Stop-Loss?

What is a Stop-Loss Order?

A stop-loss order, also known as a stop order, is a tool used by investors to buy or sell a stock once it reaches a specified price during trading. The aim of a stop-loss order is to mitigate risk by allowing you to set a limit of how much you could lose on a position. 

For example, investors can set a stop-loss order for 15% lower than the price you bought the stock for. This means your loss won’t be more than 15%.

Say you bought a share in Tesla (TSLA) after its recent stock split. Trading at $1,374.39 at the time of writing. Once you buy the stock you create a stop-loss order for $1,000. If the stock falls, (as Tesla shares have) your shares will be sold at the current market price.

What’s an Example of a Stop-Loss Order?

Let’s walk through a hypothetical example of a stop-loss order to make sure we’re on the same page.

This image shows ho a stop-loss order can close your position at a certain price point so that you can prevent potential losses.
A stop-loss order can play a crucial role in minimizing losses when trading stocks.

A trader purchases 100 shares of ABC for $100 and places a stop order of $90. The stock drops over the coming weeks until it is below $90. The stop order is executed and the trader sells their shares for $89.95.

The idea here is that the trader likely believes that if the shares of ABC were to decline to $90, they would decline even further. To protect against those further losses, the stop order can come in handy — as the trader is not required to constantly monitor the activity of ABC shares.

The Good and the Bad with Stop-Loss Orders:

Pros

  • Can lock in profits 
  • “Set it and forget it”
  • Loss is limited
  • Doesn’t cost anything
  • Prevents emotional decision making

Cons

  • Gains are limited
  • A temporary price drop could activate it 
  • The sale price might be below the stop price
  • Does not suit volatile stocks

Advantages of the Stop-Loss Order ✅

Okay, so let’s start with the obvious: it won’t cost you a penny to implement. You will be charged your usual commission once the stop-loss price is reached and the stock is sold. You can think of a stop-loss order as a kind of insurance policy – except it’s free!

Another benefit of a stop-loss order is that it frees your mind from making overly emotional decisions. In general, people tend to get emotionally attached to stocks and hope that it will regain its performance in time. In reality, this mindset might just cause your losses to accrue further.

Availability heuristic is a cognitive bias within us all. It causes our brains to take a kind of mental shortcut through the information we’ve consumed when we’re making decisions or trying to predict certain outcomes. 

This image illustrates the vast difference between what information most traders have when making a decision, and all the important information that exists.
An availability heuristic can negatively influence our decision making process.

Our cognitive biases can intrude on our perceptions of risk and lead us astray, in some cases. Being aware of this bias by using stop-loss rules can help you safeguard against fallacious reasoning.

No matter what type of strategy you employ, you should be able to outline exactly why you own a stock. Value investors will have different criteria to growth investors, which will be different again to that of an active trader. 

At the end of the day, your strategy will only be successful if you stick to it. If you’re a buy-and-hold investor, a stop-loss order won’t do you much good.

Lastly, it’s vital to understand that a stop-loss order is not a guarantee that you’ll make a profit in the stock market; you will still need to use your knowledge and experience to recognize smart investment opportunities. If you don’t have this ability to begin with, a stop-loss order won’t be much help when it comes to losses over the long run.

💡 You’ll be able to complete stop-loss orders with the top stock brokers.

Stop-Loss Orders Can Help Secure Profits 📈

Stop-loss orders are not just for stopping losses. They are also a great way to lock in profits. Let’s consider an alternative situation where the stock you’ve researched and chosen doubles in value. Do you lock in your profit by selling it before it reaches its full potential? 

Or do you hold onto it, crossing your fingers, only to find out that any potential loss you could have made has now dissipated back into the darkness of the stock market. For this reason, stop-loss orders can be potentially more useful for locking in profits, then stopping losses.

This image illustrates how a stop-loss order can secure profits by closing your positions before it goes below a certain price.
Stop-loss orders are also a way to lock in profits.

Disadvantages of Stop-Loss Orders ⚠️

Of course, there are a few problems with stop-loss orders. The main disadvantage is that sudden, and short-term drops in the price of a stock could activate the stop price. 

To help prevent this you’ll need to try and determine a percentage that gives the stock flexibility to move, while also mitigating the downside risk. Choosing to set a 10% stop-loss order on a stock when it has a history of fluctuating more than 15% in a week is probably a poor strategy. You’ll probably just miss out on the profit made from the execution of the stop-loss order.

There is no right or wrong way to set a level for the stop-loss order, it will completely depend on your own investing style. Active traders may use a level of 5%, while a long term investor could choose a lovely of 15% or over.

Something else to bear in mind: once your stop price is reached, your order changes to a market order. So, the price your stock is sold at might not be the same as the stop price. This becomes particularly real in a volatile market with little sign of Covid-19 getting under control any time soon. It is therefore important that investors act decisively to mitigate any potential issues.

Another disadvantage to a stop-loss order is that most brokers restrict you from putting a stop order on particular securities. For example, even the top penny stock brokers will prevent you from placing stop orders on penny stocks.

Furthermore, while a stop-limit order can guarantee a price cap, the trade might not get executed. This can cause damage if a stop order is triggered in a fast market, but the limit order isn’t completed before the market price moves through the order limit.

If the company receives some bad news coverage and your limit is not too far below the stop-loss price, you will need to hold onto the stock for an undetermined amount of time until the stock price goes up again. Both order types can be entered as either good-until-canceled (GTC) or day orders. 

Overview & Summary

There are five key considerations with stop-loss orders:

  1. In many cases, investors can benefit from a stop-loss order.
  2. The aim of a stop-loss order is to limit losses on a security position that goes against your favor.
  3. Stop-losses can also be used to lock in profits.
  4. Stop-loss orders have no added cost and can prevent emotional decision making.
  5. A key disadvantage of a stop-loss order is that a short-term price drop could activate the stop price and trigger a sale.

Can You Use Stop-Loss Orders When Shorting?

Short-sellers can also benefit from a stop-loss order by capping losses incurred during a short-sale. Short-selling, especially through the use of put options, is a strategy used by some investors that involves betting on a declining security. A position is open by borrowing shares and then selling them with the hopes that they can buy it back later at a cheaper price, thus earning a profit.

If an investor needs a stock, they can issue a stop-loss buy order at a certain price. This can be done for mobile traders, who use popular investment apps. The order will only execute if the price of the stock hits the stop-loss price which triggers the buy-order execution and closes out the short-position. 

Because the ask price is the amount that the investors can buy shares, the stop-loss order is set at the ask price. We’ve rounded up the top brokers for short-selling, taking into consideration tools, fees, customer service, and more.

Difference Between Stop-Loss and Stop-Limit

Stop-limit orders are similar to stop-loss orders. However, like their name suggests there is a price limit on the execution. A stop-limit order has two prices: the stop price that converts the order to a sell order, and the limit price. 

Instead of the stop-limit order becoming a market order to sell, the sell order becomes a limit order that executes only once it reaches the price limit or better.

Both stop-loss and stop-limit orders carry unique benefits.

With this order type, you are never guaranteed that it’ll be filled (it’s more of a hope), especially during price swings. Sometimes stop-limit orders are preferred because if the price of the stock falls lower than the limit, the investor will want to keep the stock until the price rises again.

For example, lets say ABC stock never falls to the stop-loss price, and instead it steadily rises until it reaches $100 per share. The investor can cancel the stop-loss order at $91 and put a stop-limit order at $97, with a limit of $95 If the stock drops lower than $97, then the order switches to a sell-limit order. 

Were the stock to continue dropping below $95, then the order stays unfilled unless the prices rises above $45 again.

Benefits and Risks of Stop-Loss and Stop-Limit Orders ⚖️

Stop-loss orders and stop-limit orders can offer protection in different ways. Stop-loss orders will ensure your order is executed, but the price might slip upon execution. 

In the majority of cases, sell-stop orders are filled once the price drops below the strike price; it defers mostly based on how quickly the price falls. An order might be filled for a significantly lower price if the price plunges fast.

🔎 Want to learn more? See our guide to stock trading.

What Price is Used to Trigger a Stop-Loss? 📉

In most cases, the broker looks to the current market bid price. This is the highest price that investors will pay for the stock at that time. Should the bid price rise to the set stop-loss price, the order will be executed, and the stock will be sold.

Where the broker usually refers to the ask price to execute the stop-loss sell-order, in this case they refer to the bid price. The broker refers to this price because it’s the amount that the seller can realistically get in the market at that time.

Looking back to our example, a stop-loss order made for 20 shares of TSLA at $325.50 cap any potential loss, and the investor would gain a $10.50 profit per share if the stock drops (market price of $325.50 minus $315 cost basis = $10.50.

The only risk posed by a stop-loss order is that it might stop out. Stopping out can occur when a security hits a stop-loss point unexpectedly, and activates the order. This could result in a loss on a trade that could have otherwise earned a profit had there not been a sudden stop.

This would be a particularly frustrating situation if the prices dropped like they do in a market flash crash – plummeting but then rebounding after. Despite how fast the prices recover, once a stop-loss is triggered, you can’t reverse it.

🚨Don’t set your stop-loss order too close to the current price—a spike in volatility can close your position prematurely.

In some cases, the stop-loss order might have been set higher than needed which would cause the investor to make less than they would have had they invested more on a lower rock bottom.

The Bottom Line

On one hand, some experts believe that stop-loss orders can be easily implemented, yet in most cases, investors fail to utilize it in the best way. When used correctly, stop-loss orders are viewed as a way to cap losses and lock in profits.

On the other hand, some experts recommend avoiding stop loss orders for downside protection. Getting out of the market at a 10% loss won’t help you navigate the market better in the future, nor will it help you understand how to re-enter. 

In many cases, investors get out and then stay there until the market goes well beyond the triggering values. When prices fall, attempting to rebalance a portfolio would require selling bonds and investing more in the markets, not simply getting out of the market.

Stop-Loss Order FAQs

  • Do Stop Loss Order Always Work?

    Stop-loss order can be an effective tool, but that is not to say that they always work, and must be used with caution. This is especially true in volatile markets.

  • Can a Stop Loss Order Fail?

    A stop-loss order might not be successful in limiting loss because when the stock hits the stop price it triggers a sale but doesn’t guarantee the price it will be sold at. This can happen when the stock opens at a low price.

  • Should I Put a Stop Loss Everyday?

    Stop losses cannot be set for longer than a day. That said, there are lots of sites offering the option to receive price alerts. If you want a stop loss at Rs. 100 for example, you can simply set a price alert at Rs 105 and you’ll get an alert in time. To help get the best results even while on-the-go, you could consider using one of the most effective stock trading apps.

  • Where Should I Set My Stop Loss?

    Stop-loss orders can be placed with a broker to sell securities once they hit a specified price point. These orders cap the loss that an investor might be subject to. If the stop loss order is set at 10% under the price you bought the security for, you will lose 10% at most.

  • What is a Trigger Price in a Stop Loss Order?

    A trigger price is the price that you enter when you place the stop loss order. Note, this is not the same as the price the order is executed at - this is the limit price.

  • How Long is a Stop Limit Order Valid?

    A buy or sell limit order is valid for 45 days. The order can be placed during and after market hours, and investors can specify how many days they would like to place the order for.

  • Can I Place a Stop Loss and Limit Order at the Same Time?

    Yes, you can place a limit order and a stop loss at the same time. This is called a bracket order and is typically done for stocks.

  • Can You Put a Stop Loss Order on an ETF?

    Yes, stop loss orders can be placed on ETFs. If the ETFs falls suddenly below its net asset value, a stop-limit order can be used. This stops your sale from going too low. However, this isn’t the best strategy. If you are looking to invest in ETFs, make sure to go with one of the most renowned ETF brokers in the industry.

  • Do Professional Traders Use Stop Losses?

    Professional traders use mental stops. In this way, they don’t need to let others know where their stop loss is by putting it on the market.

  • How Do I Set A Stop Loss Order on Robinhood?

    With Robinhood, you can set a stop price lower than the current price of the stock. If the stock drops to your stop price, it will trigger a sell limit order. The stock will only be sold once it reaches your limit price or more.

  • How Do I Set a Stop Loss on TD Ameritrade?

    When using the thinkorswim platform from TD Ameritrade, brackets can be set up with a stop and stop limit order while placing a trade. Simply go to the Trade tab, choose the stock you want to trade, and select Buy custom from the menu.

  • What is the Difference Between a Stop Loss and a Trailing Stop?

    The biggest difference between a stop loss order and a trailing stop is that a trailing stop order moves up by the trail amount as the price of the position moves up.

Get Started with Stop-Loss Orders

Congrats on making it this far! 🎉

Now that you understand the full functionality of stop-loss orders, the next step is to find a reliable broker. Here are a few brokers trusted by traders across the globe:

Fees
Commissions

$0

$0

Account minimum

$500

$0

Minimum initial deposit

$0

$0

General
Best for

Beginners and mutual fund investors

DIY stock trading

Highlight

Low fees

Pioneer of commission-free stock trading

Promotion

Free stock

Rating
Fees
Commissions

$0

Vary

Account minimum

$0

$0

Minimum initial deposit

$0

$0

General
Best for

DIY stock trading

Active traders

Highlight

Pioneer of commission-free stock trading

Huge discounts for high-volume trading

Promotion

Free stock

Rating
Fees

Commissions

$0

$0

Vary

Account minimum

$500

$0

$0

Minimum initial deposit

$0

$0

$0

General

Best for

Beginners and mutual fund investors

DIY stock trading

Active traders

Highlight

Low fees

Pioneer of commission-free stock trading

Huge discounts for high-volume trading

Promotion

Free stock

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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