When using any type of trading exchange like FOREX, or stocks and shares, you can execute different types of orders. An order is essentially a set process involving the buying and/or selling of an item on the exchange with set parameters. One of the most common types is the stop loss order. In this guide, we explain what a stop-loss order is, its pros and cons, and how to use it for trading.
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Stop loss order – a method to limit your potential losses
Stop Loss Order = An order placed with an exchange/broker to sell a specific item (stock/currency etc.) once it reaches a set price.
Confused?
Let’s give an example.
You buy shares in Apple at $10 per share. After buying shares, you create a stop loss order at $9. Therefore, if the stock prices drop to $9, your order is triggered, and your shares are sold for $9 each.
As you can see, this type of order enables you to minimize losses during market slumps. It also allows you to lock profits as explained below.
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Understanding stop-loss orders
Stop-loss orders are not the same as limit orders that are only made when the security can be sold or purchased at a certain price or a better one. A stop-loss order is able to lock in a particular profit amount in a trade.
So, let’s say that a trader buys a stock at $3 a share then the price goes all the way to $6 a share. In this case, the trader may decide to put the stop-loss order at $4 a share. This way, they are able to lock in a $1 per share profit in case the stock price drops back down to $4 per share.
When a security’s price goes all the way to or beyond the stop-loss order price that the trader specified, the stop-loss order turns into a market order. As a result, there will be a sale or purchase performed at the greatest price available.
Stop-loss orders may not be performed at the exact stop price level specified by the trader when the market is moving rapidly. However, it will be selected pretty close to the specified stop price. At the same time, all traders should keep in mind that protection is not always provided by stop-loss orders. In more extreme cases, you may not be able to benefit from the protection you want.
Let’s imagine the following scenario: a trader buys a stock at $25 per share. Then, a stop-loss order is placed at $20 per share. During one trading day, the stock closes at $22 a share. But once the trading closes for that day, there is some bad news about the firm.
In case the stock price gaps much lower on the market the following trading day, respectively below $20, the stop-loss order set at $20 will be activated. The order was made to protect the trader in case the price would drop.
However, when the price drops too much – for instance, $10 – it will not be close enough to the $20/share specification. So, it will have to be filled close to the prevailing market price, respectively $10 a share.
The order can be filled at the order price you specified or even better when you use limit orders. When stop-loss orders are triggered, you can rest assured that there will be immediate execution of the order, and it will be filled at the market price that prevails at that specific moment.
Purposes of stop-loss orders
Stop-loss orders serve one goal – to make trading easier and more convenient and to decrease risk exposure. Trading can be made easier by having an order in place already, an order that can get executed automatically when the market trades at a certain price. Meanwhile, risk exposure is reduced when potential losses get limited.
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Stop-loss orders are useful, and they are always recommended to traders, especially to those who trade frequently. Traders can use them when they enter trades, as this can help them avoid possible losses and limit risks. As such, stop-loss orders can help decrease risk considerably, and this is achieved by limiting how much capital is risked during one trade.
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Where to place a stop-loss order when buying
If you’re new to trading, you may not know how to deal with stop-loss orders. Therefore, placing them in the right spot may be challenging.
Most of the time, a trader will look at the market volatility and fluctuation, as well as the historical asset movement. Then, if the trader wants to go short, the stop-loss will be placed above the market price. Meanwhile, if the trader wants to go long, the stop-loss will be placed under the market price.
Alternative points to place a stop-loss order
There is no rule when setting stop-loss orders. Putting the stop-loss under the market price when going long or above the market price when going short is not mandatory. In fact, you can always settle for an alternative point on the price chart.
Traders usually take advantage of technical indicators to do this. Therefore, you can use the indicator as a stop-loss order. Some indicators have a buy signal, and in this case, you can place the order at the price level where your indicator doesn’t tell you that you should go long anymore.
You can also use the Average True Range, which tells you how much price movement there is as time goes by. Some traders also consider volatility when choosing stop-loss order placement points.
Advantages and disadvantages of stop loss orders
Now that we have given an example of a stop loss order, we can delve into its pros and cons.
Advantages
Stop loss orders can be hugely beneficial when used correctly. They offer the following benefits:
- Can be viewed as a free insurance policy
- Less monitoring of price fluctuations
- Removes the “emotional” aspect of trading
Firstly, a stop loss order is a de-facto insurance policy. It doesn’t cost anything to place a stop loss order and commission is only deducted when the order is triggered. Many traders, therefore, use this type of order to simply minimize their losses and have a safeguard against huge, unexpected price drops.
Secondly, using stop loss orders means you do not have to continually monitor prices. Trading can be a drain and intense, therefore anything you can use to limit your work is a bonus.
Lastly, using stop loss orders helps reduce the emotional aspect of trading. Oftentimes we can get attached to a specific asset – this can negatively impact our decision-making process. Stop loss orders help remove the emotional aspect and make trading purely automated and mechanical.
Disadvantages
Although they have many benefits, there are drawbacks to consider too including:
- Short-term price fluctuations could trigger the stop loss
- Trades can sometimes not execute
- Once the price is triggered, the market price may already be different
The main downfall of stop loss orders is when used on assets that have rapid price fluctuations. For example, it would not be a good idea to set a stop loss order of 5% below the market price, for an asset that regularly moves up or down by 5%. Ultimately, you would end up simply paying a commission and continually losing money.
Secondly, there is no guarantee that the trade will execute. The stop-loss order is simply executing a trade – someone still has to buy that trade and there is no guarantee that your order will be matched. In fast-moving markets, stop loss orders could sometimes fail to process as a result. Your stop loss order could trigger, and the market price could have already changed thus meaning you could end up stuck in an unfavorable position.
How to use stop loss orders
Stop loss orders are used in two primary ways. Firstly, to reduce potential losses as the name implies. Secondly, to lock in profits when used as a trailing stop.
Loss reduction
Traditionally, people place stop loss orders to do exactly as the name suggests – to stop losses. By losses, we mean exponentially greater losses. For example, by setting a stop loss order at 10% below the market price you are negating potentially greater losses if the prices fall to 15% or 20% lower, for example. It’s a de-facto insurance policy.
Trailing stop
You can also use stop loss orders to make consistent profit safely. This is known as the trailing stop. You can set a stop loss order as a percentage below the market price – not the price you bought at.
As the market price changes, so does your stop loss order. This can lead to making consistent capital gains without the need to continually monitor price fluctuations.
Conclusion
We hope you have found this guide on stop loss orders useful. As you can see, the stop loss order is a useful tool to have at your disposal. It can help reduce potential losses from price slumps, but it can also help lead to consistent profits when used as a trailing stop loss.
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