Stop-Loss Order

What is a Stop-Loss Order?

A stop-loss order is a risk management tool used by investors and traders to limit their potential losses in case a position does not yield the expected result.

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It is an order placed with a brokerage to sell a security (for long positions) when it reaches a certain price, known as the stop price. Selling at the stop price results in the maximum loss that the investor is willing to accept if the price security keeps declining.

How Does a Stop-Loss Order Work?

Investors place stop-loss orders by providing their broker with details including:

  • The ticker symbol of the security they would like to trade;
  • Selecting the stop-loss order type;
  • The number of securities to sell;
  • The stop price. 

The order stays open until the security’s market price falls to or below the predefined stop price. Then, the stop-loss order becomes a market order, and the position is sold at the best available price. This helps investors limit their downside risk.

For example, an investor buys 100 shares of a stock at $50 per share. They place a stop-loss order with their broker at $45 per share. If the stock price drops to $45 or lower, the stop-loss order is triggered, converting to a market order, and the 100 shares are sold at the prevailing market price, which could differ slightly from $45.

Stop-Loss Orders on Short Positions

Stop-loss orders can be used on both long and short positions. A long position is the most common one, where the investor expects that the price of the security will rise in the future. 

However, sophisticated traders use short positions to bet against the performance of a security. For example, if they expect that the value of a stock will decline, they borrow the shares from their broker with the expectation of buying them at a future date at a lower price to close the position.

In these cases, the stop-loss order, instead of selling the security at the stop price, will be used to repurchase the asset if the price starts to rise, as this results in losses for the short seller.  

Slippage Risks

Slippage refers to the difference between the stop price the investor sets and the actual price at which the securities are sold (or bought for short positions). This occurs during periods of elevated market volatility or if the asset is highly illiquid and brokers struggle to fulfill the order rapidly.

When a stop-loss is triggered, it turns into a market order to sell the security at the next best available price. However, in fast-moving markets, this price could be much lower than anticipated.

The liquidity of the security also impacts slippage on stop-losses. If trading volumes and liquidity are low, it becomes harder for market makers to find buyers to take the other side of the trade order. This forces the execution further down through multiple price levels and increases slippage.

The consequences of slippage on stop-losses include:

  • Increased Losses: Rather than limiting losses to a defined threshold like 5% or 10%, slippage could result in a larger loss on the position beyond what the investor originally expected.
  • Gap Risk: Price gaps between trading sessions or after news events can result in sharply lower opening prices. Stop-losses may be triggered when these price gaps occur, exacerbating slippage effects.
  • Price Uncertainty: The actual execution price becomes more unknown, reducing the reliability of stop-loss orders to achieve their intended goal.

To mitigate some risks from slippage, investors can utilize wider stop-losses, trailing stops, or stop-limit orders, which add a price limit for execution after the initial stop-loss trigger.

However, these also have tradeoffs to evaluate. Managing slippage remains an inherent challenge with most stop-loss order types.

Advantages

The main advantages of using stop-loss orders include the following:

Advantages Description
Managing Risk Stop-losses limit potential losses if a security’s price starts declining rapidly. Investors can use them to set limits based on their risk tolerance and define stop prices accordingly.
Emotion Control Stop-losses enforce discipline, overriding emotional biases that may otherwise convince investors to hold losing positions for too long.
Automatic Execution Once triggered, stop-loss orders are automatically executed without the need to manually enter a market order. This ensures that swift action is taken if losses are starting to pile up.

Disadvantages

Meanwhile, potential drawbacks of using stop-loss orders include the following:

Disadvantages Description
Price Changes In fast-moving and highly volatile markets, stop-loss orders may execute at prices significantly below the specified stop price due to wide bid/ask spreads or rapidly falling security prices.
Fees Many brokers charge trading commissions and fees to execute stop-loss transactions. These transaction costs increase the losses resulting from a position that is closed once it hits the stop price.
Early Triggers Prices can fluctuate temporarily before moving in the expected direction. This can result in a premature trigger for a stop-loss order.

How to Choose a Stop Price?

Choosing an appropriate stop-loss price involves balancing risk tolerance with some room for normal price fluctuations. Some common methods include:

  • Percentage: A fixed percentage below the purchase price based on the maximum acceptable loss. A 10% stop-loss would trigger after a 10% decline in the price of the asset.
  • Volatility: Setting the stop price based on the level of expected volatility provides a buffer for usual price fluctuations. Highly volatile securities need wider stops.
  • Support Levels: Technical analysis can help traders identify where the support levels for security are, and these can be used as the stop price. These levels indicate that buying activity may step in to push prices back up when the price of the asset approaches that area. Hence, they serve as guidance for traders to set their stop prices.
  • Trends and Patterns: These are stop levels that allow room for existing downward trends and price patterns to continue without prematurely closing the position.

Types of Stop-Loss Orders

There are several variations of stop-loss orders investors can use:

Standard Stop-Loss Order

The most basic type triggers a market order to sell when the stop price threshold is reached. Execution occurs at market prices.

Stop Limit Order

This is a more advanced order with two components: the stop price, which triggers the next step, and a limit order that is executed once the stop price is reached. The limit order is used to protect traders from the impact of slippage during volatile market periods.

Trailing Stop-Loss

The stop price automatically adjusts upward as the price rises to lock in profits but still prevent downside risk. This order trails the market price by a set percentage or amount and is executed only if the price falls below that threshold compared to the current market price.

The Bottom Line

Without a stop-loss order in place, investors are exposed to taking unlimited losses on both their long and short positions. 

Hence, this type of order is a great tool to protect portfolios from being dramatically impacted by unfavorable downturns.

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Alejandro Arrieche Rosas

Alejandro has seven years of experience writing content for the financial industry and more than 17 years of combined work experience, serving under different roles in multiple business fields including tech and financial services. Before joining Techopedia, Alejandro collaborated with numerous online publications such as Seeking Alpha, The Modest Wallet, Capital.com, Business2Community, EconomyWatch.com, and others, covering finance, business news, trading platform reviews, and educational articles for investors. Alejandro earned a Bachelor's in Business Administration from UNITEC, Venezuela, and a Master's in Corporate Finance from EUDE Business School, Spain. His favorite topics to cover are value investing and financial analysis.