When an investor places a stop-loss order, sometimes referred to as a stop order, they order their broker to buy or sell a stock once shares reach a certain price. This price is called a “stop price.” Placing a stop-loss order can potentially help keep people from losing money.
There are several types of stop-loss orders, too, that investors can use to increase their chances of retaining any applicable returns. Knowing what they are, and how to use them, can be beneficial to many investors.
What Is a Stop-Loss Order?
A stop-loss order is a market order type that automatically executes a transaction once certain parameters are met — those parameters being set by the investor. In effect, a stop-loss order limits an investor’s potential losses, by “locking in” their profit or gain in relation to a given position.
It may be helpful to think of stop-loss orders as a set of instructions given to your brokerage or investment platform that will automatically execute a trade once a security reaches a given price.
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How Stop-Loss Orders Work
Stop-loss orders work by executing a predetermined order or set of instructions set by an investor or trader. Effectively, an investor can decide that if the value of one of their stocks falls below a certain threshold, they’ll want to sell it, thereby preserving the gain or profit they’ve made on the stock’s appreciation over time.
So, if the stock’s value starts to fall, and hits the threshold decided upon by the investor, an automatic sell order will execute, and the investor’s position will be vacated – or, their stocks will be sold automatically. This way, if the stock continues to lose value, the investor’s already cashed out, and they won’t lose any more value if they had held onto their stocks.
Different Types of Stop-Loss Orders
There are a few key types of stop-loss orders investors should know about:
Sell-stop Order
A sell-stop order is an order to sell a stock when shares hit a certain price. Let’s look at two examples. The first shows how sell-stop orders can help investors limit their losses.
Daniel buys 10 shares of Stock X at $150 each. He knows he could lose money, but he wouldn’t be comfortable losing more than 10% of what he initially invests.
To ensure he doesn’t lose more than 10%, Daniel sets up a sell-stop order for $135, which is 10% less than he originally paid for his shares of Stock X. If Stock X shares drop to $135, his broker will immediately sell them, so he only loses 10%.
By setting up a sell-stop order, Daniel has limited his losses. (Remember, 10% is just an example, not a suggestion. Everyone has different preferences when investing.)
Now let’s look at an example of how a sell-stop order can lock in profits. This time, Daniel buys 10 shares of Stock Y for $100 each. Six months later, shares have increased to $150 each.
Daniel doesn’t want to lose any of his unrealized gains. “Unrealized gains” are the gains investors make when share prices increase, but they haven’t sold their shares, so they haven’t collected any of the money yet.
Daniel’s Stock Y shares have increased by $50, or $500 total. If the share price drops below the original $100, he could lose all those unrecognized gains.
But Daniel isn’t ready to sell his Stock Y shares yet, either. If the share price continues to increase, he wants to keep earning money. So, he sets up a sell-stop order.
Now that the Stock Y share price is $150, Daniel might set up a sell-stop order for, say, $130. If shares drop to $130, his broker automatically sells them.
Although Daniel wouldn’t be able to keep the full $500 he could have earned had he sold his shares at $150, he would still pocket $30 per share, or $300 total.
In the example of Daniel’s Stock X shares, he prevented losses. With his Stock Y shares, he’s locked in gains. When trading, you’ll probably hear the term “market order” pop up frequently. Know that a stop-loss order is not the same as a market order. When people place market orders, they buy or sell stocks at the current market price, whatever that may be. With a stop-loss order, people “schedule” a market order that is triggered once a predetermined price has been hit.
So once a stock hits its stop price, the stop-loss order becomes a market order. The stop price isn’t necessarily the same price that the shares will be sold at.
For example, Daniel’s stop price for his Stock Y shares is $130, but by the time they sell, they may have dropped to $125.
As a result, he loses more money than he’d anticipated. Or the share price could increase to $135 when they sell, so Daniel only loses $15 per share, even though he was prepared to lose $20.
Buy-stop Order
Knowing what a sell-stop order is, a buy-stop order is similarly exactly what it sounds like. Investors set up a buy-stop order to purchase a stock once shares hit a price higher than the current market price.
Buy-stop orders are placed under the assumption that once a stock starts to increase, it will gain momentum and continue to rise.
If Daniel knows that Stock S shares generally sell for between $20 and $25, he might set up a buy-stop order to purchase 10 shares once they reach $26. The computer system would buy 10 shares on his behalf, and he’d hope Stock S share prices would continue to rise.
Trailing Stop-loss Order
Regular sell-stop orders and buy-stop orders are set at a specific dollar amount. Trailing stop-loss orders are different.
When someone sets a sell trailing-stop order for a certain amount, it tracks (or “trails”) the stock and sells shares once they decrease by that amount. A buy trailing-stop order “trails” the stock and buys shares once they increase by that amount.
Let’s look at an example with real numbers to break it down.
Let’s say Daniel buys shares of Stock A for $40 each. He sets a sell trailing stop-loss order for $1. As long as the stock increases, he’ll hold onto his shares. But as soon as the share price dips by $1, Daniel’s broker will sell his shares of Stock A.
If Stock A’s share price drops from $40 to $39, Daniel’s broker will sell his shares. And if the share price gradually increases to $44 but then drops to $43, a sell trailing-stop order for $1 will cause his broker to sell shares at a stop price of $43. (But remember, because a stop-loss order turns into a market order, shares might be at a price other than $43 by the time they sell.)
Trailing-stop orders are useful for locking in gains. As long as share prices increase, investors keep their shares. Once it decreases by a predetermined amount, the stock is sold.
Advantages of Using Stop-Loss Orders
Stop-loss orders have a couple of primary advantages: Limiting losses, and locking in profits or gains.
Risk Management and Loss Limitation
The most obvious advantage of a stop-loss order is that it keeps people from losing too much money in the market. In the first example of Daniel’s shares of Roku, he set a sell-stop order so that even if he did lose money, he didn’t lose more than he was comfortable with or could afford.
Stop-loss orders aren’t just for preventing losses, though. People can also use them to secure a capital gain.
With Daniel’s stop-loss order for Stock Y, his shares increased from $100 to $150, and he set up a sell-stop order for $130 so that if the stock started to dip, he would pocket at least $30 per share, or $300 total.
If Daniel hadn’t set that sell-stop order for his Stock Y investment, he could have incurred a net loss. Hypothetically, let’s say the share price continued to drop to $90 before he finally sold. He would have lost $10 per share, or $100, rather than gained $300.
Using Stop-Loss Orders to Lock in Profits
Stop-loss orders can also lock in profits. That can lead to some peace of mind for some investors.
In other words, a stop-loss order can make the investment process less stressful. People don’t have to check in on their stocks three times per day, five days per week to track share prices and decide whether they want to buy or sell.
Stop-loss orders help remove other emotions from the process, too. It can be easy to make irrational or rash decisions when trading stocks.
Daniel might get emotionally attached to his Stock Y shares, so he holds onto it even when it becomes a bad investment. Or he tells himself he’ll sell once Stock Y shares drop 10%, but he has a hard time pulling the trigger.
Some people are the type to “set it and forget it.” They buy stocks and forget to check in on them at all. Daniel might say he’ll sell his Stock Y shares when the price decreases 10%, but he simply forgets to check the market for three months. Stock Y’s share price continues to drop, and he loses significant money.
Stop-loss orders can be ideal for investors who want to “set it and forget it” and they have the potential to reduce portfolio risk if used appropriately.
Disadvantages and Risks of Stop-Loss Orders
Stop-loss orders can have some drawbacks, too, just as they have potential advantages.
Potential Drawbacks and Market Impact
Stop-loss orders can work against investors when there’s a short-term drop in the share price, or drawback.
Consider this: Maybe Daniel buys 20 shares of Stock B for $30 per share. He sets a sell-stop order for $28.Monday, shares are at $30, but they fall to $28 on Tuesday, so his broker automatically sells all 20 shares. By Friday, shares have jumped up to $33, so Daniel has lost $60 in just a few days because there was a short-term dip.
It’s helpful to research how much a stock tends to fluctuate in a given amount of time to avoid these types of problems. Maybe Stock B’s share price regularly fluctuates by a few dollars at a time, so Daniel should have set his stop-loss order at a lower price.
If investors understand their stocks’ trends, they can probably set up stop-loss orders more strategically. However, research goes out the window when there is a “flash crash.” This is a sudden, aggressive drop in stock prices — but prices can jump back up just as quickly.
Flash crashes aren’t common, but they occasionally occur.
In this case, Daniel’s Stock B shares could drop from $30 to $15 in the morning, and because he set up a sell-stop order, they automatically sell. But the share price jumps to $32 by the time the closing bell sounds, and Daniel loses out on those gains because he had a sell-stop order.
Understanding Price Gaps and Slippage
Another drawback to consider is that once a stock hits its stop price, the stop-loss order becomes a market order, or an order to sell a stock at the current market price. When a stop-loss order becomes a market order, shares sell for the next available price — or, what’s often called a price gap.
If the difference between an investor’s stop price and the next available price is a few cents, it might not be a big deal. But if the market is volatile that day and the market price is several dollars below the stop price, someone could end up losing quite a bit of cash — especially in the case of a flash crash.
Granted, a stop-loss order turning into a market order could be either a pro or a con, depending on whether a share price increases or decreases. Regardless, some investors might consider it a disadvantage to not know what to expect.
When and Why to Use Stop-Loss Orders
Investors can choose to use stop-loss orders in a variety of scenarios, but they can likely be most beneficial if an investor feels that a security’s price is likely to fall in the near future, or if they’re particularly risk-averse and want to lock in their gains.
With that in mind, there may not necessarily be an ideal scenario in which a stop-loss order is best used or deployed — it’ll depend on the individual investor’s goals and concerns. Again, if they’re particularly risk-averse or at a point in their life where they can’t wait for the market to rebound, and want to lock in their gains, it may be a good idea to use one. If not, a stop-loss order may be less useful.
It may be a good idea to talk to a financial professional, too, about when or if using a stop-loss order is a good idea at a given point in time.
Strategic Considerations in Various Market Conditions
If you’re uncomfortable with the risks that come with stop-loss orders, you may choose not to use them. But know that a huge purpose of stop-loss orders is to minimize risk, and depending on market conditions, they may help ease your anxiety. Even so, it might be helpful to think about the trade-offs and whether the pros outweigh the cons, in your particular financial situation.
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Setting Stop-Loss Order Levels
While each and every investor will have different considerations to make when setting stop-loss order levels, there are some things to broadly keep in mind.
Determining Price Levels for Stop-Loss Orders
There’s no exact science when determining price levels for stop-loss orders. It really comes down to an investor’s risk threshold — or, how much loss they’re willing to stomach before they want to bail on a position. Again, that will vary from investor to investor.
It may be helpful to think of that threshold in terms of a percentage. For instance, if a stock’s value declines by 10%, would you want to sell? How about 20%? These can be broad, general markers that many investors can utilize. But there are more advanced methods, too, like using moving averages to determine an acceptable stop-loss placement.
You could even use support and resistance levels to work as guidelines, too. It depends on how thorough or exact you’d like to be.
The Takeaway
Stop-loss orders are a type of market order that can be helpful to investors who want to preserve their gains, or who may want to limit their risk. There’s no exact science as to when and how to use them, but they can be an important and powerful tool in any investor’s kit — though there’s no obligation to ever necessarily use them.
If you’re unsure of whether you should start incorporating stop-loss orders into your strategy, it may be helpful to talk about it with a financial professional. Again, these are just one tool of many, and if you’re particularly risk-averse, they may be worth investigating further.
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FAQ
What’s the main difference between a limit stop-loss order and limit order?
The main difference between a limit stop-loss order and a limit order is that limit orders guarantee trades execute at a specified price, whereas stop orders can be used to limit potential losses. Limit orders specify the maximum price an investor is willing to pay, where a stop-loss order specifies the threshold at which an investor wishes to sell.
Do stop-loss orders always work?
Stop-loss orders do not always work, as there can be glitches within a trading platform’s system, low market liquidity, trading stoppages, and market gaps that can throw an investor’s plans out the window.
Is a stop-loss order better than a stop-limit?
A stop-loss order is not necessarily better than a stop-limit order, as they’re two different things that can or could be used together as a part of an overall investment strategy.
Is a stop-loss a good strategy?
Using stop-loss orders may be a good strategy for certain investors, but it’ll depend on the specific investor’s overall strategy, goals, and risk tolerance. What’s good for one investor may not necessarily be good for another.
What are stop-loss rules?
Stop-loss rules are specified by investors when inputting a stop-loss order. These rules specify the price at which an investor will want to vacate a position or sell their holdings — it’s a threshold at which they want to sell and maintain their gains.
What is the best way to set up stop-loss and make a profit?
There are many strategies and tactics that investors can use to set up stop-loss orders, which might help them maintain profit and value. Some investors, for example, use a percentage as a guideline, while others might use moving averages to determine stop-loss limits, and others could use support and resistance levels.
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