What is a Stop-Loss Order?

Stop-loss orders are placed by traders either to limit risk or to protect a portion of existing profits in a trading position. Placing a stop-loss order is ordinarily offered as an option through a trading platform whenever a trade is placed, and it can be modified at any time. A stop-loss order effectively activates a market order once a price threshold is triggered.

Traders customarily place stop-loss orders when they initiate trades. Initially, stop-loss orders are used to put a limit on potential losses from the trade. For example, a forex trader might enter an order to buy EUR/USD at 1.1500, along with a stop-loss order placed at 1.1485. This limits the trader's risk of loss on the trade to 15 pips.

Key Takeaways

  • A stop-loss order is designed to limit an investor's potential loss on a trade.
  • The stop-loss effectively triggers a market order to buy or sell once a pre-set price threshold is reached.
  • The advantage of a stop-loss order is you don't have to monitor how a stock is performing daily.
  • The disadvantage is that a short-term fluctuation in a stock's price could activate the stop price.

How to Use a Stop-Loss Order

Once a trade is showing a moderate profit, a trader commonly adjusts the stop-loss order, moving it to a position where it protects part of the trader's profits in the trade. Continuing with the previous example, assume that after the trader buys EUR/USD at 1.1500, the price subsequently goes up to 1.1600. At that point, the trader may move their stop-loss order up to 1.1540, thus protecting almost half of their existing profit in the event the market turns down.

Traders sometimes use trailing stops to automatically advance their stop-loss order to a higher level as the market price rises. Trailing stops are easily set up on most trading platforms. The trader simply specifies the number of pips, or dollars, that they wish the stop order to trail behind the market high. Still using the EUR/USD example, if the trader specifies a 50-pip trailing stop when the market reaches 1.1600, the stop will automatically shift to 1.1550. If the market then rises to 1.1620, the stop will be advanced higher to 1.1570.

Stop-loss orders are a critical money management tool for traders, but they do not provide an absolute guarantee against loss. If a market gaps below a trader's stop-loss order at the market open, the order will be filled near the opening price, even if that price is far below the specified stop-loss level.

Stop-limit orders are similar to stop-loss orders, but as their name states, there is a limit on the price at which they will execute. There are two prices specified in a stop-limit order: the stop price, which will convert the order to a sell order, and the limit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price or better.