What is a stop-loss order?
A stop-loss order is an order to buy or sell a stock whenever the price reaches a predetermined price level. The purpose of this order is to protect traders and investors from losing money on trades if the stock price moves against them.
Example of a stock-loss order
Let’s assume that you took a long position in the following stock when it was trading at $10 per share as shown in a chart below. Because you are not sure 100% about the future direction of the price, you decided to set up a stop-loss order at $9.85 per share.
Unfortunately, the price moved against you and the price tanked a day after you took a position in the stock.
Since the price dropped below your stop-loss order, your order became a market order to sell all or the number of shares you specified. That is your shares were sold at the best market price possible right after the price went below $9.85 per share.
You can clearly see that you could be losing a lot of money if you did not use a stop-loss order. Why would you be losing money on this trade? Because you took a long position and the price tanked a day before you bought shares in the stock.
Benefits of a stop-loss orders
The main benefit of a stop-loss order is to protect you from major losses whenever the price goes against you. For example, you will not have to watch a stock all the time when there an order to stop your losses in place.
When trading, may traders tend to use emotions instead of strategies. Having a stop-loss in place will protect you from losing money because you believe that a stock will go up. There is no guarantee that a stock will go back up. Therefore, if your position is turning into a loser, a stop-loss will act on your behalf.
Disadvantages of stop-loss orders.
Although a stop loss will protect you from major losses, there are a lot of drawbacks associated with it.
The main drawback is that you have no control over how much you will lose per share. This is because once the stock price goes below your stop-loss value, the order will become a market order.
This means that your shares will be sold at the best market price possible. If the price tanked with a high percentage, your shares could be sold at a big loss.
The other drawback is that you could lose money on a winning trade due to short term fluctuations. For example, let’s assume that your investment strategy is swing trading. So, you took a short position in a stock hoping that it will go down in the few coming days. You also played it smart and used a stop-loss order to cover you in case the price goes up.
Due to fluctuation in the price, the price went above your stop-loss value before tanking. In this case, your order was executed and you lost money on this trade.
In other words, the stop-loss kicked you out too early. You could be making money in your order was not executed.
Should I use a stop-loss order?
Yes, you should always use a stop-loss order. Even though there are drawbacks associated with this order, it will protect your portfolio and give you a chance to trade again. That is, the order will limit your losses to a minimal and manageable percentage.
You must understand that there is no guarantee of how much your order will be executed. This is because your order will become a market order to sell your shares once the price breaks below your stop value. Your shares could be sold at a much lower or much higher value than you wanted.
Final Words
Always use stop-loss orders for every position you take. You never know the direction of the stock price. Therefore, using a stop-loss will protect you when the price goes against you.
It is equally important to invest money based on your risk tolerance. That is, never invest more than you can afford to lose.
Happy trading and investing!
