What with so many facets to look at and brood over when weighing a stock buy, it's easy to forget about the little things. The stop-loss order is one of those little things, but it can also make the world of difference. Just about everybody can benefit from this tool in some way. Read on to find out why.

What Is a Stop-loss Order?
It is an order placed with a broker to buy or sell once the stock reaches a certain price. A stop-loss is designed to limit an investor's loss on a security position. Setting a stop-loss order for 10% below the price at which you bought the stock will limit your loss to 10%. For example, let's say you just purchased Microsoft (Nasdaq:MSFT) at $20 per share. Right after buying the stock you enter a stop-loss order for $18. This means that if the stock falls below $18, your shares will then be sold at the prevailing market price. (For further reading, see A Look At Exit Strategies.)

Positives and Negatives
The advantage of a stop order is you don't have to monitor on a daily basis how a stock is performing. This is especially handy when you are on vacation or in a situation that prevents you from watching your stocks for an extended period of time.

The disadvantage is that the stop price could be activated by a short-term fluctuation in a stock's price. The key is picking a stop-loss percentage that allows a stock to fluctuate day to day while preventing as much downside risk as possible. Setting a 5% stop loss on a stock that has a history of fluctuating 10% or more in a week is not the best strategy. You'll most likely just lose money on the commissions generated from the execution of your stop-loss orders.

There are no hard and fast rules for the level at which stops should be placed. This totally depends on your individual investing style: an active trader might use 5% while a long-term investor might choose 15% or more. (For further reading, see Limiting Losses.)

Another thing to keep in mind is that once your stop price is reached, your stop order becomes a market order and the price at which you sell may be much different from the stop price. This is especially true in a fast-moving market where stock prices can change rapidly.

A last restriction with the stop-loss order is that many brokers do not allow you to place a stop order on certain securities like OTC Bulletin Board stocks or penny stocks.

Not Just for Preventing Losses
Stop-loss orders are traditionally thought of as a way to prevent losses thus it's namesake. Another use of this tool, though, is to lock in profits, in which case it is sometimes referred to as a "trailing stop". Here, the stop-loss order is set at a percentage level below, not the price at which you bought it, but the current market price. The price of the stop loss adjusts as the stock price fluctuates. Remember, if a stock goes up, what you have is an unrealized gain, which means you don't have the cash in hand until you sell. Using a trailing stop allows you to let profits run while at the same time guaranteeing at least some realized capital gain. (For further reading, see Trailing-Stop Techniques.)

Continuing with our Microsoft example from above, say you set a trailing stop order for 10% below the current price, and the stock skyrockets to $30 within a month. Your trailing-stop order would then lock in at $27 per share ($30 - (10% x $30) = $27). This is the worst price you would receive, so even if the stock takes an unexpected dip, you won't be in the red. Of course, keep in mind the stop-loss order is still a market order - it's simply stays dormant and is activated only when the trigger price is reached -- so the price your sale actually trades at may be slightly different than the specified trigger price.

Advantages of the Stop-Loss Order
First of all, the beauty of the stop-loss order is that it costs nothing to implement. Your regular commission is charged only once the stop-loss price has been reached and the stock must be sold. You can think of it as a free insurance policy.

Most importantly, a stop loss allows decision making to be free from any emotional influences. People tend to fall in love with stocks, believing that if they give a stock another chance, it will come around. This causes procrastination and delay, giving the stock yet another chance. In the meantime, the losses mount....

No matter what type of investor you are, you should know why you own a stock. A value investor's criteria will be different from that of a growth investor, which will be different still from an active trader. Any one strategy may work, but only if you stick to the strategy. This also means that if you are a hardcore buy-and-hold investor, your stop-loss orders are next to useless. (Read more about these different approaches in the Guide to Stock-Picking Strategies.)

The point here is to be confident in your strategy and carry through with your plan. Stop-loss orders can help you stay on track without clouding your judgment with emotion. (See The Importance of a Profit/Loss Plan.)

Finally, it's important to realize that stop-loss orders do not guarantee you'll make money in the stock market; you still have to make intelligent investment decisions. If you don't, you'll lose just as much money as you would without a stop loss, only at a much slower rate.

A stop-loss order is a simple tool, yet so many investors fail to use it. Whether to prevent excessive losses or to lock in profits, nearly all investing styles can benefit from this trade. Think of a stop loss as an insurance policy: you hope you never have to use it, but it's good to know you have the protection should you need it.

Related Articles
  1. Options & Futures

    Trailing-Stop/Stop-Loss Combo Leads To Winning Trades

    Combine trailing stops with stop-loss orders to reduce risk and protect portfolio value.
  2. Options & Futures

    Forget The Stop, You've Got Options

    Using options instead of stop-loss orders adds finesse and control in limiting losses.
  3. Trading Strategies

    Day Trading Strategies For Beginners

    From picking the right type of stock to setting stop-losses, learn how to trade wisely.
  4. Investing

    The Art Of Selling A Losing Position

    Knowing whether to sell or to hold is tough. And no rule fits all. Find out what to consider.
  5. Stock Analysis

    The Biggest Risks of Investing in Netflix Stock

    Examine the current state of Netflix Inc., and learn about three of the major fundamental risks that the company is currently facing.
  6. Mutual Funds & ETFs

    3 Fixed Income ETFs in the Mining Sector

    Learn about the top three metals and mining exchange-traded funds (ETFs), and explore analyses of their characteristics and how investors can benefit from these ETFs.
  7. Mutual Funds & ETFs

    Top 3 Muni California Mutual Funds

    Discover analyses of the top three California municipal bond mutual funds, and learn about their characteristics, historical performance and suitability.
  8. Mutual Funds & ETFs

    Mutual Funds Are Not FDIC Insured: Here Is Why

    Find out why mutual funds are not insured by the FDIC, including why the FDIC was created and how to minimize your risk with educated mutual fund investments.
  9. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  10. Investing News

    6 Signs You Are Addicted To Investing

    An addiction to trading can ruin your life and relationships. Not to mention the monetary costs. There are telltale signs that you've gone too far.
  1. What types of investors are best-suited for stop loss orders?

    From conservative investors to highly speculative day traders, no one likes to see a loss in a portfolio. There are several ... Read Full Answer >>
  2. What is the difference between a stop order and a stop limit order?

    Traders often enter stop orders to limit losses or capture profits on price swings. These types of orders are very common ... Read Full Answer >>
  3. What kind of risk exposure does an investor face when investing in the metals and ...

    The primary risk faced by all investors is that the price of investments they have purchased falls below the price paid. ... Read Full Answer >>
  4. What are common strategies traders implement when identifying a Bullish Harami?

    Candlestick chartists look to bullish harami patterns as signs of possible trend reversal. These patterns appear most frequently ... Read Full Answer >>
  5. Can you place a stop-loss order on a mutual fund?

    First, remember that a stop-loss order is a limit order placed with a broker to sell a stock when it reaches a certain price. ... Read Full Answer >>
  6. How does a stop-loss order work, and what price is used to trigger the order?

    A stop-loss order, or stop order, is a type of advanced trade order that can be placed with most brokerage houses. The order ... Read Full Answer >>
  7. Do stop or limit orders protect you against gaps in a stock's price?

    Many individuals are hesitant to invest in the stock market because of the large gaps in prices talked about in the news. ... Read Full Answer >>
  8. I want to buy a stock at $30, sell when it reaches $35, don't want to hang on to ...

    Once you've identified a security that you want to purchase, you need to determine a price at which you want to sell if the ... Read Full Answer >>
  9. Can a stop-loss order be used to protect a short sale transaction?

    The quick and simple answer to this question is yes. The major difference between the stop-loss order used by an investor ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  2. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  3. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  4. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  5. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  6. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!