What Is a Stop-Loss Order?
A stop-loss order—also known as a stop order—is a type of computer-activated, advanced trade tool that most brokers allow. 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.
Stop-loss orders differ from a conventional market order. With market orders, the investor specifies that they wish to trade a given number of shares of a stock at the current market-clearing price. Using a market order, the investor cannot specify the execution price. However, the stop-loss allows an investor-specified limit price.
The Stop Loss Order
How Stop-Loss Orders Work
A stop-loss order is essentially an automatic trade order given by an investor to their brokerage. The trade executes once the price of the stock in question falls to a specified stop price. Such orders are designed to limit an investor’s loss on a position.
For example, say you have a long position on 10 shares of Tesla Inc. (TSLA) that you bought for $315 per share. The shares are now trading for $340 each. You want to continue holding the stock so you can participate in any future price appreciation. However, you don't want to lose all of the unrealized gains you have built up so far with the stock. Your gains are unrealized because you have not sold the shares; once sold they become realized gains. After a review of company data, you decide that you would want to sell out of your position if TSLA shares fall 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 enter a stop-loss order to 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 the price falls to $325.50.
- A stop-loss order is an automatic trade order to sell a given stock but only at a specific price level.
- A stop-loss order can limit losses and lock in gains on stock.
- The brokerage uses the prevailing market bid price to execute the stop-loss order.
- Volatile market conditions or dramatically fluctuating individual stocks can inadvertently trigger a stop-loss order.
- Volatile conditions may also cause the final realized price to be lower than the stop-loss price.
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. The bid price is the highest price at which investors are willing to buy the stock at a given point in time. If the bid price reaches the specified stop-loss price, the order is executed, and the shares are sold.
Instead of the broker using the ask price—also known as the market-clearing price—they use the bid price to execute stop-loss sell orders. The broker uses this price because the bid price is the value a seller can receive currently in the open market. Returning to our example, a stop-loss order placed for 10 shares of TSLA at $325.50 would effectively limit potential losses, and the investor would realize a profit of $10.50 per share should the stock price drop ($325.50 market price less $315 cost basis = $10.50).
The only risk involved with a stop-loss order is the potential of being stopped out. Stopping out happens when the security unexpectedly hits a stop-loss point, activating the order. The stop could cause a loss on a trade that would have been profitable—or more profitable—had a sudden stop not kicked in. This situation can be particularly galling if prices plunge as they do during a market flash crash—plummeting, but subsequently recovering. No matter how quick the price rebounds, once the stop-loss is triggered, there is no stopping it.
The stop-loss order could also be set too high, causing the investor to realize less on a trade than if they had gambled more on a lower rock bottom.
"Set it and forget it"
Locks in profits
Avoids emotional/pressurized decisions
Could be activated by a temporary price drop/flash crash
Realized sale price could be lower than the stop price
Not suited to volatile stocks
Can You Use Stop-Loss Orders When Shorting?
Stop-loss orders can also be used to limit losses in short-sale positions. Short selling, or shorting, is a strategy that bets on a decline in a security's price. An investor or trader-seller opens a position by borrowing shares and then selling them. Before the investor has to deliver the shares to the buyer—or return them to the lender—the investor expects the share value to drop and to be able to obtain them at a lower cost, pocketing the difference as a profit.
If an investor is short a given stock, they can issue a stop-loss buy order at a specified price. This order executes if the stock's price reaches the stop-loss price triggering a buy-order execution and closing out the investor's short position in the stock.
Since the ask price is the price at which an investor can buy shares on the open market, the ask price is used for the stop-loss order.
A Stop-Loss vs. a Limit Order
A stop-loss order triggers when the stock falls to a certain price. The stop-loss is then, technically, a market order. This market order executes at the next price available. In a volatile situation, the price at which an investor actually sells could be much lower than anticipated, causing the investor to lose more money than expected.
In contrast, a limit order trades at a certain price or better. The limit order ensures that the investor does not execute the trade at a lower price than anticipated. Limit orders cost more in trading fees than stop-loss orders. Also, limits have a time horizon after which they automatically cancel. This time limitation may cause limits to cancel before they are executed if the price never reaches its trigger point.
A hybrid of the stop-loss order and a limit order is the stop-limit order. This method combines the features of a stop-loss order and a limit order. When the stock reaches a specified price, it triggers the trade as a limit order and trades only at that price or better.
While the investor is better able to control the trade price with a stop-limit order, the downside is that there is no guarantee the trade will transpire. In markets where the price is falling, the market value may drop below the limit price. In this case, buyers will buy in the open market at the lower of the two prices.
Real-Life Example of a Stop-Loss Order
The protective value of a stop-loss order can backfire during sudden, violent market drops when prices are whipsawed. That happened to many investors holding stop-loss orders during the May 6, 2010 flash crash. Hundreds of equities on the New York Stock Exchange fell by 20% or more, triggering the orders. But prices were plunging so quickly, the trading desks could not keep up. By the time orders were executed, it was at prices far below their original stop-loss triggers. To add insult to injury, many equities recovered later in the day as the free-fall only lasted a few hours.
In a May 15, 2010 article recapping the events, The Wall Street Journal cited one hapless management consultant. He owned shares of the Vanguard Total Stock Market ETF (VTI) and, the day before the crash, he set a stop-loss order on them at $49.17 per share. When—the next afternoon—they hit that price, they activated his order. However, they blew past the barrier so fast that by the time they finally sold, the price was at $41.15 per share, wiping out all the consultant's gains for the past 18 months. Frustrating—particularly since the exchange-traded fund (ETF) ended up for the day, at $57.71 per share.