What is a Stop Loss Order?
A stop loss order is the instruction placed with a broker to sell an investment when it reaches a certain price, which is specified by the trader. This is used to limit the risk on the investment, and is set at a percentage below the initial purchase price.
Deciding on the percentage at which to set the stop loss is one of the crucial aspects of applying this tool in trading. Many traders will set a stop loss at 10% below the price they paid for the investment, and what this means is that if a security was purchased for $100, and a 10% stop loss order is added, then in the event that the price of the security drops to $90, then the stop loss will be triggered. The investment will then be sold at the next available price, which may for example be $89. It is important to consider the typical volatility of a stock, and if a stock has a history of fluctuating 10% or more, then a 15% stop loss on this investment might be a better choice, as a 10% loss does not mean that the stock has begun a downward trend, and the trader would not want the position to be stopped out when it is simply fluctuating and not dropping.
The Advantages of a Stop Loss Order
One of the biggest advantages to placing a stop loss order is that this eliminates the necessity to constantly monitor the position. The trader can go about other business, with the reassurance that they are not risking a huge loss on their investment.
Another benefit to using a stop loss is that it helps to take emotion out of the trading equation. Once a stop loss has been placed at 10%, the trader doesn’t pull out of the trade at a 5% loss because of panic, keeping them in the trade long enough to realize a profit. Also they don’t stay in the trade beyond the 10% loss in the hope that it will turn around, and end up losing the entire investment.
A Word of Warning
There is no guarantee that the investment will be sold at the stop loss price. While there is a very good possibility that the price will come close to that of the stop loss order, in a very fast moving market or volatile market, there may be a greater discrepancy between the stop loss and the actual sale price. In the event that the stock closed just above the stop loss, say $91 in the example above, but then experienced a gap down, and opened the following day at $84. The stop loss would then be triggered, and the investment might be sold at $85.
Trailing Stop Loss Orders
Although the name ‘stop loss’ implies the function of avoiding loss, a specific type of order, known as a trailing stop loss, is actually used to lock in profit.
With a standard stop loss, the order is triggered if the price drops to a certain percentage of the purchase price. With a trailing stop loss, however, the order is triggered when the price drops by the dollar figure which is equivalent to the specified percentage from the current price. Taking the same figures as above, the 10% stop loss on a $100 investment would mean that the spread between the price and the stop loss is $10. Translating this into a trailing stop loss, what it would mean is that if the price had risen to $132, and then subsequently dropped to $122, the order to sell would be triggered. If the investment was then sold for $121, then a substantial profit has been realized, and the investor does not see the price continuing to drop to the $90 mark that it would with a standard stop loss before the order took effect.
Whether using stop losses to protect against major loss, or to secure profits as they are attained, almost all types of traders can benefit from using these valuable trading tools.