A stop-loss order (or simply "stop order") is a type of advanced trade order that can be placed with most brokerages. The order specifies that an investor wants to execute a trade for a given stock, but only if a specified price level is reached during trading. This differs from a conventional market order, in which the investor simply specifies that he or she wishes to trade a given number of shares of a stock at the current market-clearing price.
How Stop-Loss Orders Work
A stop-loss order is essentially an automatic trade order given by an investor to his or her brokerage – only be executed once the price of the stock in question falls to the specified stop price stated in the investor's stop-loss order. Such orders are designed to limit an investor’s loss on a position in a security.
For example, let's say you are long 10 shares of Tesla Inc. (TSLA), which you bought for $315.00 per share. The shares are now trading for $340.00 per share. You want to continue holding the stock so you can participate in any future price appreciation it may see. However, you also don't want to lose all of the unrealized gains you have built up so far with the stock, and you would want to sell out of your position if TSLA shares fell to $325.50.
Rather than watching the market five days a week to make sure the shares are sold if Tesla's price drops, you can simply enter a stop-loss order to essentially monitor the price for you. Based on the earlier example, you could input a stop-loss sell order to your brokerage to sell 10 shares of TSLA if its price falls to $325.50.
The Stop Loss Order
What Price Is Used to Trigger the Stop-Loss?
For most stop-loss orders, the brokerage house normally looks at the prevailing market bid price (i.e. the highest price for which investors are willing to buy the stock at a given point in time), and if the bid price reaches the specified stop-loss price, the order is executed and the shares are sold. The bid price is used for stop-loss sell orders (instead of the ask price or the market-clearing price), because the bid price is the price a seller can receive presently in the market. In our example, a stop-loss order placed for 10 shares of TSLA at $325.50 would effectively limit your potential losses, and you still get to realize a profit of $325.50 - $315.00 = $10.50 per share should the stock price head south.
The only risk involved with using a stop-loss order is the potential risk of being stopped out of a trade that would have been profitable, or more profitable, if the trader had been willing to accept a higher level of risk.
Can You Use Stop-Loss Orders When Shorting?
Stop-loss orders can also be used to limit losses in short-sale positions. If you are short a given stock, you can issue a stop-loss buy order at a specified price. This order will be executed only if the stock's price rises high enough to reach the stop-loss price, triggering a buy order execution and closing out your short position in the stock.
In these cases, the stop-loss order would be executed once the ask price level reaches the stop-loss price, since the ask price is the price at which an investor is able to buy shares on the open market. (For more on this, see Can a stop-loss order be used to protect a short sale transaction? )
The Differences Between a Stop-Loss and a Limit Order
A stop-loss is triggered when the stock falls to a certain price. It then becomes a market order. This market order executes at the next price available. In a volatile situation, the price you actually fill at could be much lower than anticipated, causing you to lose more money than expected.
A limit order trades at a certain price or better. This ensures you do not execute the trade at a lower price than anticipated. Limit orders generally cost more in trading fees than stop-loss orders. Plus, the time limit on the order may cause it to cancel before it is executed if the price never reaches its trigger point. A stop-limit order combines the features of a stop-loss order and a limit order. When the stock reaches a specific price target, it triggers the limit order and trades at that price or better.