Stop-Loss Order

Updated on April 11, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Stop-Loss Order (Stop Order)?

A Stop-loss order is an advanced version of a computer-activated trade tool that is mostly allowed by brokers so that the trade is executed for a particular stock if only the predetermined price levels are obtained while trading, and such types of orders are designed only for minimizing the investors’ loss burden.

Stop-Loss Order

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This order ensures a high probability of the investor achieving a predetermined entry price or exit price. Investors use this as it helps them to limit the losses and lock in the profits. Once this price crosses the determined entry point or exit point, the stop order converts into a market order.

Key Takeaways

  • A stop-loss order is a risk management strategy that traders and investors use to reduce possible investment losses by automatically executing a sell order if the asset’s price hits a certain level.
  • Stop loss orders are generally set for long trades below the current market price and short positions above the price.
  • If the market shifts against an investor’s position, a stop-loss order seeks to guard against substantial losses.
  • The use of stop-loss orders can aid in the implementation of disciplined investing strategies and assist in eliminating emotional biases in investment choices.

Stop-Loss Order Explained

The stop loss order in stock market is a tool frequently used by traders in the stock market to manage the risk of loss in the falling market. It limits the potential loss because in the trading platform the security is sold off by itself if the price of the stock fall to the stop-loss price level.

While placing the stop loss order to buy the investor specifies the stop loss price which is a calculated level beyond which the investor does not want to incur losses. If the stock price falls to that level, the stop loss order is triggered and it will be sold off, saving the investor from further loss.

When such a price order is triggered, the order turns into a market order and the sale takes place at the best available market price. It is important to note that the market price may be different from the stop-loss price. This happens when the market is very volatile.

Even though this kind of order helps the trader to manage the risk, it does not guarantee the any protection against all losses. If the market is rapidly declining or there are huge price gaps, the execution price may be far from the stop loss price. For that reason, the price should be calculated with proper analysis.

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Types

Some common types of stop-loss orders are explained below:

  • Market order – This is the basic type of order, in which once the price is triggered, the stock gets sold off at the market price prevailing at that time. It is a very quick process.
  • Stop limit order – Here, the traders add a limit price along with the stop-loss. In this, case, if stop loss is triggered, the sale execution is done at or higher than the limit price. It gives better control on the loss but the order may not be executed if the limit price is not reached.
  • Trailing stop-loss – In the case of a trailing stop loss order , it is a percentage or a fixed amount which is below market price for long and above market price for short position.
  • Stop-loss with protection – In this case, the price includes a cushion or protection to manage minor fluctuations in the market prices.
  • Order with options – This is used by option traders. They are designed for the purpose of option contracts, and the price is set as per the price of the underlying asset of the contract.

Methods Of Calculation

Some frequently used methods of such kind of price calculation are explained in detail below.

Stop-Loss Order

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#1 – Percentage Method

Let us consider that an investor is comfortable with losing 10% of the value of Apple’s share and is now trading at $100. Then they would set a stop-loss order at (100*10%) = 10=100 – 10 = 90

#2 – Support Method

The support method is based on technical indicators and also based on the current trend as the investor identifies a support level and places a stop loss order to buy at that price. For example, the investor considers the support method of the Apple stock to be $80. Then stop-loss order would also be set at this level.

#3 – Moving Average Method

The moving average method calculates the moving average typically for a longer period of time and then, on the basis of that, places a stop-loss order below that level. The moving average of Apple is at $80; then, in the moving average method, the stop order can be placed at $79.

Examples

Let us try to understand the concept with the help of some suitable stop-loss order example.

Example #1

Let’s assume an investor owns a hundred Apple shares, and bought the share at $100 per share. The share is expected to reach $120 in the next month, but they do not want to risk it going the other way.

The broker puts a stop order at $90. In this case, if the stock goes up, all the profits will be realized. But if the store goes down and touches $90, the order will automatically be a market order and place.

It is not necessary that the order will be placed at $90; it can also happen that it will be placed either at $89 or at $91 based on the market conditions.

Stop Order Example

Example #2 – Portfolio

In this stop-loss order example, the portfolio size is $1,00,000, and the risk one are willing to take is 1%. The total risk for the portfolio, which one is willing to take, is 1%, which equals $1000.The position size is $12,500. This is the total amount of risk one are willing to take.

The stop-loss order is placed at 8%, and the current share price is $50. Therefore, considering the stop-loss order at 8%, the share price and the risk investors are willing to take are $46 per share. That is the total amount of loss per share at $4.

Instead of stop-loss, if the protection were on the gain, then at 20%, the total profit would have been $60. Similarly, at 30%, it would have been $65, and at 40%, it would have been $70.

This is how stop-loss or gains are calculated based on the total portfolio amount and the risk investors are willing to take.

Advantages

Before getting on to the advantages of trailing stop loss order or any other type, one crucial point to discuss is that the benefit to one trader could be a disadvantage to others.

  • Monitoring: The most vital advantage of a stop order is that it does not have to be monitored. The investor does not have to check continuously how the stock is performing. This is useful when the investor is on a vacation or any action that prevents him from checking on the stocks for an extended period.
  • Protection from Downside: When the prices fall, a stop order helps the investor to lock in losses and prevents the investor from incurring additional losses.
  • Known risk: The order works at a predetermined price; thus, the investor knows how much risk they will take if they incur losses. This is important for money management. The investor can also figure out the risk-reward ratio. This ratio helps calculate the risk investors are willing to trade for the potential profit.
  • Cost: There is no additional cost to make a stop-loss order in stock market. The commission is charged only when the price has been reached. Then the order converts into a market order, and the purchase/sale is completed.
  • Objective: These orders help eradicate the financial bias and let the investors trade on investment goals rather than an emotional attachment.

Disadvantages

  • Volatile Market/ Market Fluctuations: The stop price is a predetermined price. When the market is volatile, the stop price could be activated when it was not intended to because of the short-term fluctuations.
  • Price Guarantee: As discussed above, once the stop-loss order is activated, it becomes a market order. In case when the market is falling rapidly, there is no guarantee that the losses will be locked at the predetermined price. It will be different, and the losses will be higher than expected.
  • Stop-loss orders can trigger a rapid sell-off of securities at times of market crash. They have contributed to the rapid sell-off and the stock market crash in 2008. Stop loss was triggered as the prices began to fall in October 2008. This flooded the market with sell orders, which made the prices decline further. When demand outpaces supply, prices tend to fall rapidly. The cycle of falling prices and triggering the stop loss will add to the steepness in case of a market decline.

Stop-loss Order Vs Limit Order

Let us try to understand some differences between the two types of orders given above.

  • The former is used to protect against the losses in an order whereas the latter is used to buy or sell a security at a particular price of better than it.
  • For the former, the stock is sold off if the price is hit, and for the latter the stock may be bought or sold at the limit price.
  • The former controls the losses whereas the latter controls the execution price.

Thus, the above are some of the differences of both the prices.

Frequently Asked Questions (FAQs)

How does a stop loss order work?

Stop-loss orders are established at a certain price level that is either above or below the current market price for long and short positions. The asset is automatically sold when the price reaches or drops below the predetermined level, activating the stop-loss order and reducing potential losses.

What are some considerations when using a stop loss order?

Investors should choose the stop loss level based on risk tolerance, investment goals, and market volatility. For example, setting the stop loss too close to the current price may result in the frequent triggering of orders, while setting it too far may lead to substantial losses. Therefore, it’s essential to strike a balance.

Do stop-loss order expires?

Stop-loss orders can have different expiration types depending on the instructions provided by the investor. There are generally three expiration options for stop-loss orders: day order, good til canceled order, and good til date order.

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