Investing in the stock market can fill our minds with “what ifs.” What if we choose the wrong stocks? What if we lose money? What if we buy a stock right before the share price plummets? What if we wait too long to sell a stock, or we sell too early?
The market will always involve some level of risk, but it’s possible to remove a few of those “what ifs” from our heads. One way investors can put their minds at ease is by setting up stop-loss orders.
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.
Are you a control freak?
Then playing the stock market might fill you with a sense of dread. However, stop-loss orders can help give people a sense of control by doing two things: Limiting how much money they lose or ensure they do make money from a stock they already own.
There are a few different types of stop-loss orders: sell-stop orders, buy-stop orders, and trailing stop-loss orders.
Types of Stop-Loss Orders
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 Roku 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 Roku. If Roku 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 Nike for $100 each. Six months later, shares have increased to $150 each.
Daniel doesn’t want to lose any of his unrecognized gains. “Unrecognized 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 Nike 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 Nike shares yet, either. If the share price continues to increase, he wants to keep earning money.
So, how can Daniel make sure he keeps at least some of the money he’s gained? By setting up a sell-stop order.
Now that the Nike 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 Roku shares, he prevented losses. With his Nike 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.
For example, Daniel’s stop price for his Nike 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.
Now that you know what a sell-stop order is, a buy-stop order is 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 Pinterest 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 Pinterest 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 AT&T 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 AT&T.
If AT&T’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.
The Benefits of a Stop-Loss Order
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 Nike, 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 Nike 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. Stop-loss orders can lock in profits.
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. Instead, they can set a stop-loss order and move on with their lives.
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 Nike stock, so he holds onto it even when it becomes a bad investment. Or he tells himself he’ll sell once Roku 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 Roku shares when the price decreases 10%, but he simply forgets to check the market for three months. Roku’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.
Last but definitely not least, a major benefit of stop-loss orders is that they’re free! People may have to buy insurance for your car or home, but they don’t have to pay extra for these types of orders.
The Downsides of a Stop-Loss Order
Stop-loss orders can work against investors when there’s a short-term drop in the share price.
Maybe Daniel buys 20 shares of General Motors 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 General Motors’ 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 if there’s an error or glitch in the market computer system.
In this case, Daniel’s General Motors 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.
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.
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.
Using a Stop-Loss Order
If you’re uncomfortable with the risks that come with stop-loss orders, you may choose not to use them. That’s fine. But know that a huge purpose of stop-loss orders is to minimize risk. It might be helpful to think about the trade-offs and whether the pros outweigh the cons, in your particular financial situation.
If you’re not sure whether or not using stop-orders fits into your financial strategy, consider speaking with a professional who can offer additional insight.
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