What is a ‘Stop-Loss Order’
An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit an investor’s loss on a position in a security. Although most investors associate a stop-loss order only with a long position, it can also be used for a short position, in which case the security would be bought if it trades above a defined price. A stop-loss order takes the emotion out of trading decisions and can be especially handy when one is on vacation or cannot watch his/her position. However, execution is not guaranteed, particularly in situations where trading in the stock is halted or gaps down (or up) in price. Also known as a “stop order” or “stop-market order.”
BREAKING DOWN ‘Stop-Loss Order’
With a stop-loss order for a long position, a market order to sell is triggered when the stock trades below a certain price, and it will be sold at the next available price. This type of order works well if the stock or market is declining in an orderly manner, but not if the decline is disorderly or sharp.
For example, if you own shares of ABC Co., which is currently trading at $50, and want to hedge against a big decline, you could enter a stop-loss order to sell your ABC holdings at $48. This type of stop-loss order is also called a sell-stop order. If ABC trades below $48, your stop-loss order is triggered and converts into a market order to sell ABC at the next available price. If the next price if $47.90, your ABC shares would be sold at $47.90.
But what if ABC closes at $48.50 one day, and then reports weak quarterly earnings after market close? If the stock gaps down, and opens at $44.90 the next day, your stop-loss order would be automatically triggered and your shares sold at the next available price, say $45. In this case, your stop-loss order did not work out as you expected, since your loss on ABC is 10% rather than the 4% you had expected when you placed the stop-loss order.
This is a major drawback of stop-loss orders, and is a reason why experienced investors use stop-limit orders instead of stop-market orders. Stop-limit orders seek to sell the stock at a specified limit price – rather than the market price – once a specified price level is breached. Although stop-limit orders will also not work if the stock is halted down or has a price gap, the risk of the long position being sold at a significantly lower price than the specified stop price is lower than with a stop-market order.
Note that these orders can also be used to protect unrealized gains, although in this case it would be more accurate to refer to them as stop orders rather than stop-loss orders.