What is a Protective Stop?

A protective stop is a stop-loss order deployed to guard against losses, usually on profitable positions, beyond a specific price threshold.

Key Takeaways

  • A protective stop is a stop-loss order deployed to guard against losses, usually on profitable positions, beyond a specific price threshold.
  • A protective stop offers trading discipline to investors by helping them make important decisions about cutting losses, but can also, at times, mitigate profitable opportunities.
  • A protective stop is a popular strategy for risk-averse investors who can use tools, such as downside deviation and semivariance, to measure a security's risk threshold.

Understanding Protective Stops

A protective stop is a strategy designed to protect existing gains or thwart further losses by means of a stop-loss order or limit order. A protective stop is set to activate at a certain price level and normally guarantees that an investor will make a predetermined profit or lose a predetermined amount. For example, if one buys a stock for $50 and wishes to limit losses to 10%, or $5, one would simply set a protective stop at $45.

A protective stop offers trading discipline to investors by helping them make important decisions about cutting losses, but can also, at times, mitigate profitable opportunities. In other words, it can act as both a risk-averse strategy and a profit-averse nightmare. Because it assumes that a security will continue to fall past the exit target, a protective stop can sometimes backfire with volatile securities that have a wide trading range. Hence, it is prudent to consider the behavior of the security when using or setting a protective stop. Because the "stop" acts as a floor, a subsequent rebound in that security after hitting the protective stop guarantees that the investor will be "stopped out" prior to the advance.

A protective stop is a popular strategy for risk-averse investors. Often, their tolerance for losses is far lower than other defined investor personalities. Popular tools for measuring risk include downside deviation and semivariance. Both measures are effective risk management techniques that can be added to a position and automatically triggered, often without a financial advisor's intervention.

A common rule of thumb from behavioral finance says investors experience the pain of loss two to three times as much as the joys of a gain. This phenomenon has come to be called prospect theory. As financial advisors increasingly add psychological factors to asset management, techniques like the protective stop should grow in popularity.