A close look at a stock order type designed to reduce an investors risk.

Matthew

Updated: Jul 6, 2021 at 4:50PM

Brokerages execute a variety of stock order types for investors to buy and sell stocks. Most of these order types indicate to the broker an investors preference to purchase or sell a stock at a desired (or better) price. Other order types enable investors to reduce their risk of losses on trades. A stop-loss order is a type of stock order that enables an investor to limit the potential loss on a stock position by setting a price limit that triggers the stocks trade.

A stop-loss order triggers the sale of a stock (or a purchase for investors buying to cover a short position) once the stocks price reaches a certain value. Investors create stop-loss orders to automatically sell stocks (or cover short positions) once the stocks price reaches the trigger price set by the stop-loss order.   

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Stop-loss order example

Investors often use stop-loss orders to limit their losses on new positions. Lets say an investor purchases 100 shares of a hot new tech stock of a company that recently completed its initial public offering (IPO) at $25 per share. To limit the potential loss on this stock purchase, the investor sets a stop-loss order at 20% below the purchase price, which equals $20 per share.

If the price of the red-hot tech stock declines to $20, then that triggers the investors stop-loss order. The investors broker proceeds to sell the stock at the prevailing market price, which may be exactly at the $20 trigger price but can be much lower, depending on the the nature and timing of the stocks price movements.

Advantages of the stop-loss order

Investors use stop-loss orders as part of disciplined strategies to exit stock positions if they dont perform as expected. Stop-loss orders enable investors to make pre-determined decisions to sell, which helps them avoid letting their emotions influence their investment decisions.

Other advantages of a stop-loss order include:

  • Brokers dont charge for setting up stop-loss orders (although some still charge commissions on the actual trades), making them essentially a no-cost insurance policy to limit losses on investments.
  • Routine use of stop-loss orders helps investors become more disciplined about selling losing stocks.   

Disadvantages of the stop-loss order

There are disadvantages to using stop-loss orders. First, establishing a stop-loss order doesnt limit an investors loss to the difference between the purchase price and the pre-determined sale price. If a company reports disappointing earnings after the market closes, for example, then its share price by the start of the next trading day could be well below an investors stop-loss price.

Another potential pitfall of stop-loss orders is that they can trigger a stock sale even if the stocks price dips only slightly below the trigger price before quickly recovering. If a stocks price is volatile or another event occurs that causes a brief sell-off by other investors, that can trigger an investors stop-loss order.

Finally, during sharp market declines, sophisticated investors like hedge fund operators sometimes try to take advantage of the existence of stop-loss orders. Known as stop hunting, traders short stocks already in decline in order to push prices lower in an attempt to trigger a flood of stop-loss orders. These investors subsequently start buying those same stocks to profit from an expected rebound.

Why do investors use stop-loss orders?

Investors primarily use stop-loss orders to limit their losses on stock positions and reduce their portfolio risks. While stop-loss orders can be useful, its important to realize they dont always work as intended. Stop-loss orders can also lock in avoidable losses, which is why The Motley Fool favors buying and holding quality stocks to build wealth over long periods of time.

The Motley Fool has a disclosure policy.

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