Definition

Stop-Loss Order

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What is stop-loss order? 

A stop-loss order is a predefined advance order to buy in or sell off securities or assets when reaching a particular price. It is often an automated order that investors place with their broker/agent and, in turn, pay a certain amount of brokerage. A broker/agent who has received a stop-loss order sells a security/asset when it reaches a pre-set price limit. The purpose of placing such an order is to limit loss or gain from trade. The concept is used in short-term and long-term trading. Other names for stop-loss orders are a ‘stop order’ or sometimes a ‘stop-market order’.   

Highlights
  • The purpose of placing a stop-loss order is to cut losses at a given current market price.
  • The concept is used in short-term and long-term trading.
  • It creates a risk-reward balance for traders and investors.

Frequently Asked Questions (FAQ) 

How does stop-loss order work? 

A stop-loss order mentions the highest price for a security at which the investor wants to buy it or the lowest he wants to sell. An investor places a stop-loss order to cut losses at a given current market price. When received by a trading company or broker, he records the price limit set and takes action accordingly. Generally, the order is automated at the price level. It is often a tool used for short-term investment planning or to monitor pressure changes in a security price daily.

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Example of a stop-loss order 

Suppose an investor Fish buys a stock at USD100 and thinks that he cannot bear more than USD95. So, Fish can place a stop-loss order with his brokerage to sell the stock if it reaches USD95. Once this order is placed, Fish can rest assured that his asset will not generate a loss of more than USD5 risk.  

What purpose does stop-loss order fulfill? 

Stop-loss orders are targeted towards the reduction of risk exposure and show utility by limiting potential losses. In addition, such orders make trading easier as an automated order is already in place that can be executed if the market trades at a pre-set price.

Traders are strongly urged always to use stop-loss orders to limit their risk and avoid a potentially catastrophic loss whenever they enter a trade. Stop-loss orders make trading less risky by limiting traders’ capital risked on a single trade.

Using a stop-loss order, individuals can manage their losses effectively without monitoring the market daily and closely. As a result, it is particularly beneficial for risk-averse individuals aiming to make substantial profits through stock market investments while minimising the exposure to market fluctuations.

It also helps traders and investors exit a position before it reaches an un-perceived highest or lowest value.

What are the pros and cons of stop-loss order? 

A stop-loss order has the following advantages- 

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  • It helps cut down or minimize losses while ensuring the investor against an all-engulfing huge dip in the stock market prices. If a stop-loss order is in place, a steep fall in price stocks traded can be avoided.
  • It brings in benefits of automation to an investor or a trader’s portfolio. Stop-loss order is triggered automatically in case a stock touches a predefined price limit. There is no need to keep track of each security.
  • It creates a risk-reward balance for traders and investors. They can define the amount of risk they are willing to take on security, and the reward gets fixed accordingly.
  • A stop-loss order also promotes investing discipline, which is important to remain free from market sentiments. It helps investors pursue their financial plans and strategies and promotes disciplined trading. 

Few disadvantages of stop-loss orders are-

  • A stop-loss order being automated and predefined does not avoid short-term market fluctuations. It gets triggered even if the fluctuations are temporary and gets recovered in some time. The stop-loss order does not avoid such cases which do not actually prove to be downside risks.
  • With stop-loss, there remains a risk of being stopped out of a trade too soon and limited profit potential. Stocks are sold off quickly using it. Thus a trader does not get a chance to predict future profitability or rather increase his profitability on one stock by assuming a higher level of risk. 
  • The tricky part of a stop-loss order is the price limit investors set beforehand. For this, investors often take advice from experts, which is a costly affair and everyone can’t afford. 
  • A period of adverse fluctuations cannot be predicted easily by an investor; thus, sometimes the stop loss order can also not turn out well. Stop-loss orders can also yield significant losses, as sometimes individuals fail to recover even the principal amount while losing all capital gains.
  • Stop-loss orders are not fully immune to a free-falling crash in stock markets. However, they do help individuals with a low-risk appetite and ensure losses are capped.

How stop loss differs from limit order? 

limit order is executed when security is saleable or purchased at a specified price or for better. A buy limit order facilitates purchase when the security price falls below a pre-set limit. A sell limit order gets triggered when the security price rises over a pre-set value. These orders enable investors to maximize profitability by widening the bid-ask spread. 

However, a stop-loss order is triggered only when the price is equal to a predetermined price, being used by investors for minimizing losses, usually in a bear market. If the price level of security goes beyond the stop-loss order price, it gets converted into a market order to buy or sell at the best available prices. Thus, there are chances it may not get filled at the exact specified stop price level. 

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