What is a Stop Loss?

The world of investing is full of uncertainty and change. These fluctuations are part of the allure for investors to engage with others in the pursuit of profit. However, this attraction can also contain anxiety.

Even with years of study, no one can say definitely how stocks will or won’t perform or what prices will or won’t be achieved. Looking for tools and strategies that can help you weather the changes and keep healthy profits in your accounts? Stop loss is the strategy many turn to every day.

Stop Loss Definition

A stop loss order is an order that indicates to a broker that the shareholder wants to sell the stock at a pre-determined price if the market price drops below that limit. A market order is issued at the limit price and the stock is sold at the next available price.

Wondering why? Triggering a Stop Loss OrderThe use of the stop loss order helps prevent the investor from incurring more loss than desired. For example, if a shareholder owns shares of stock purchased at a priced of $100 and the stop loss order is placed at 10%, a market order will be automatically triggered if this stock price reaches $90.00. See the image for this example of a stop loss order being triggered at $90.00.

Please note, while in most cases your stock would be sold at $90.00 there are other rare scenarios where the price could be sold slightly less. This is because when the order is triggered the shares are then sold at the prevailing market bid price. This is the amount purchasers are willing to pay for the stock at the time the stop loss order goes in. If this price is $89.50, the stock will be sold at that price. The investor then only takes on a loss slightly over 10%. There are scenarios where there is a large gap in prices or due to after hours trading that the stock may skip a little and be sold at a lower price. Also note, if the stock does not reach the order limit, the order will not go into effect.

Why Use a Stop Loss?

In the above example, if there wasn’t a stop loss order in place, the investor could potentially lose much more than the limit set. The price may have dropped more rapidly than anticipated and the shareholder may not have time to submit a market order before the losses mount. Because the market order is automatically triggered with a stop loss order, the investor does not have to monitor the stock price constantly. For someone who has other tasks to attend to, this is a critical feature.

Additionally, using a stop loss order can help prevent knee jerk reactions to the natural changes in the stock market prices. Sometimes, investors become emotional over these fluctuations and can make quick decisions based on those feelings. These determinations aren’t always best for the long term goals the investor has likely set for the portfolio. A stop loss can keep transactions on a rational level not ruled by emotion.

How Do I Know If a Stop Loss is Best?

There are three instances when a stop loss may be a part of the best strategy for your investment goals:

  • When you need freedom. If an investor isn’t employed as a full time trader, constantly watching the market activity throughout the day can not only be tedious but nearly impossible. Without the capability of setting automated requests based on pre-determined limits and goals, an investor with another job or other duties can miss out on sale opportunities.
  • When limiting losses is a main goal. Stop losses can be critical tools in helping to limit losses when stock prices drop below a desired level. If you know that a certain business is having difficulties and you wish to cut your losses at a reasonable rate, you can use the stop loss order to set that limit and then leave the stock to do as it will. You will be able to control, within certain limits, the amount you lose on the sale of the stock.
  • To avoid emotional responses. If you tend to make decisions based on the emotion invoked by stock market changes, a stop loss can be used to help prevent that reaction. Once you set the stop loss limit, the market order goes on automatic pilot. You don’t have time to agonize over every dip and rise in price. If the price goes below your limit, the order will be submitted, without any further action from you.

Stop Loss Pros and Cons

Just as with any strategy relating to investing, there are pros and cons to using stop losses. The pros can include:

  • Providing a type of insurance against loss. The stop loss helps prevent losses from escalating well beyond set limits. The protection is maximized when stocks perform at a steady rate.
  • Helps promote consistency. Because stop loss orders are automated, an investor can set them up and take advantage of consistently preventing losses as a part of a healthy strategy. This is important in maintaining balance.Using a Stop Loss Order to Lock in Gains
  • Simple to use. Using stop loss orders helps investors easily abide by the single rule of investing: let the winners ride and cut the losses. Trailing stop losses are another strategy to ensure you lock in your gains!

The cons to using stop loss orders can be:

  • Your broker knows your sell price.Many people avoid tracking their stop loss or trailing stop loss amount in their brokerage account because they do not want the massive brokerage to know your trigger points. If the brokerage knows the trigger points for thousands of investors in a stock they could make decisions based on that knowledge. This is why many people have turned to StopLossTracker to maintain their trailing stop and stop loss amounts outside of their brokerage accounts.
  • Loss limits are not guaranteed. Although the investor can use a stop loss to set loss limits, there are times when a stock price has gaps in the price changes that can result in sale prices below the desired limit.
  • Hands off doesn’t work for some. Some investors are in a position to watch the market changes throughout the day and don’t have much need for automated stop losses.
  • More advanced traders may need more. Experienced investors may need more options than the simple stop loss offers (See “What Is a Trailing Loss Stop”).

The Last Word

In conclusion, using stop losses as a part of a well-rounded investing strategy is important for investors who wish to build in the optimal plan for gaining profit and managing losses. Stop loss orders maintain a consistent, automated line of communication between shareholders and brokers and allows freedom for the investor to do research on other investments or simply enjoy other endeavors.

Automatic market orders that can help limit losses go a long way towards offering this protection. Shareholders can allow the market to do what it does, in all its unpredictable glory, while enjoying the security of stop loss limit protection.