When it comes to buying and selling stocks, investors have several options, including using techniques involving stop loss orders. It's important to understand how this type of order works; because they can limit a loss in a volatile stock market.
In this article, we're going to explain the concept of a stop loss order. As part of that explanation, we're going to provide a simple definition of the term. Next, we're going to run through some examples demonstrating how these orders can limit losses, or preserve gains, in an unpredictable stock market. Finally, we're going to cover the pros and cons for these types of orders.
Stop Loss Orders
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A stop loss order, also known as a "stop order" or a "stop-market order" is defined as an order placed with a broker to buy or sell a stock when the price of the stock reaches a pre-defined price, which is known as the stop price. Once the price of the stock reaches the stop price, the instruction to buy or sell then becomes a market order.
There are several variations of the stop loss order, each with a considerably different objective:
Sell Stop Order: this kind of order is used by investors to limit a loss, or protect a gain, in the event the price of a stock decreases. A sell stop order has a stop price that is below the current market price.
Buy Stop Order: investors can use the buy stop order to purchase stocks as insurance against a loss, or protect a gain from a short sale. A buy stop order has a stop price that is above the current market price.
Trailing Sell Stop Order: the stop parameter for a trailing sell stop order is based on a trailing change in the actual decrease in the stock's price. This type of order is used to maximize profit as a stock's price increases, or minimize a loss when the stock's price is decreasing.
Trailing Buy Stop Order: the stop parameter for a trailing buy stop order is based on a trailing change in the actual increase in the stock's price. This type of order is used to maximize profit when a stock's price decreases, or minimize a loss when the stock's price is increasing.
Stop-Limit Order: this is an order combines the features of a limit order as well as a stop order. With a stop-limit order, once the stop price is reached, the instruction is a limit order to buy or sell the stock at the specified price.
Stop Loss Order Examples
In the following sections, we're going to give an example for three different order types. Each example should help the investor to better understand how each type of order can be used to protect a gain or to limit a loss.
Example 1: Sell Stop Order
Investors place sell stop orders when they're concerned that a stock they're holding may drop in value, and they want to limit a loss, or lock in a gain.
In this example, the investor owns a stock valued at $30 per share, and they would like to sell it if the price drops by 10% or more. In this case, the investor issues a sell stop order at $30 minus 10% or $27. If (or when) the stock's price reaches $27, the sell stop order is converted to a market order and the stock is sold at the next available price.
Example 2: Buy Stop Order
Investors typically place buy stop orders to cover a short sale. Investors that sell stocks short believe the price of that stock is going to decline. If the price declines, then the investor has a right to buy it at the lower price and realize a profit. But if the stock increases in price, then the investor will need to buy it at a higher price.
In this example, the investor places the order at $30 per share, which is above the current market price of $27. If the price of the stock moves above $30, then the buy stop order becomes a market order, and the stock is purchased at the next available price.
Example 3: Trailing Stop Order
Investors will place a trailing stop order if they want to maximize a profit when a stock's price is rising, and limit a loss when its price falls.
In this example, the investor places a trailing stop sell order at $30 per share with a $3 trailing stop, or a stop price of $27. If the price of the stock falls to $28, then the order is not executed because the stop price was not reached.
If the stock's price increases to $40, then the trailing stop order is reset to $40 minus $3 or $37. If the price of the security falls to $37, then the trailing stop order is converted to a market order, and it's sold at the next available price.
Pros and Cons
There are several important advantages of stop loss orders:
Monitoring Prices: since the order is automatically triggered by the movement of a stock's price, the investor does not have to monitor the price per share on a daily basis.
Cost: there is no cost to place a stop loss order. A commission is charged only when the stop loss order's price is reached, the order becomes a market order, and the purchase or sale is completed.
Objectivity: these orders allow the investor to remove all emotional attachments to a company's stock, and allow the investor to make trades based on the return on investment goals for each stock owned.
There are also several important disadvantages of stop loss orders:
Price Guarantees: once the stop loss order is activated, it becomes a market order. In a rapidly falling market, there is no guarantee the selling price will be the same as the stop price. In fact, it's likely to be different, and the loss will be higher than expected.
Restrictions: a broker or dealer may not allow a stop order to be placed on some securities including Over the Counter (OTC) and / or penny stocks.
Market Fluctuations: in a volatile market, a sudden and unexpected short-term increase or decrease in the stock's price could activate the order.
Stock Market Crashes
This last point is an important one because stop loss orders can, and do, contribute to a rapid sell-off of securities during a market crash. In fact, this action is believed to have contributed to the stock market crash of 2008. As the price of stocks began to fall in October 2008, stop loss orders were triggered, flooding the market with sell orders and a surplus of stocks.
When the supply of stocks outpaces demand, prices will continue to decline. This cycle of declining prices and the programmatic triggering of stop loss orders will inevitably add to the steepness of any market's decline.
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