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Stop-Loss Orders & How They Work

July 25, 2022
5
min

Learn all about how stop-loss orders can help investors achieve a variety of goals by setting floor and ceiling prices that can limit a loss or lock in a profit.

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A stop-loss order is a type of trading order that occurs when a stock, commodity, derivative, exchange-traded fund (ETF) or some other investment reaches a certain price. It can be used when selling to limit a loss or—despite the name—to lock in a profit.

What is a stop-loss order? 

A stop-loss order is an order to sell or buy a stock or other investment if it reaches a certain price. When the conditions are met, the stop-loss order becomes a market order—an instruction to buy or sell now at the prevailing market price. 

Traders often use this order type as a tool to limit losses on an investment. That might be a floor price on a holding that’s done poorly and an investor is unwilling to risk further losses. This floor price would be set via a sell-stop order.

A stop-loss order could also be used for an investment that has risen in value but that is starting to decline. The order means the investment will be sold once the price falls to a certain point, guaranteeing a profit before it loses more value. 

Stop-loss orders also are a tool short sellers—investors who profit when a security falls in price, but lose when it rises— sometimes use. They set a ceiling price that will trigger a sale, thus containing losses. 

Stop-loss orders can be placed through a broker or by using an online trading app.

How do stop-loss orders work? 

Here’s how a stop-loss order might work. Consider an investor who bought shares of XYZ Corp. at $35 and they’ve now risen to $50. The investor hopes the shares will rise more but doesn’t want to risk a sudden plunge that wipes out the gains. So the investor places a stop-loss order at $45. If shares don’t fall to $45, nothing happens, and the investor can always decide to cancel the order or perhaps set a new stop-loss strategy at a different price. If the shares do fall to $45, the order triggers a market order and the investor sells the stock for a profit of $10 a share.

Although stop-loss orders are a way to sell at a specified price, they do have a downside: If the price never reaches the target, the order won’t be executed. So if an investor wants to be sure a sale takes place, they would place a market order at the current price. 

There is one other potential downside to stop-loss orders: The target price isn’t necessarily the price at which the order will be executed. Imagine an investor who sets a stop-loss target at $50 for XYZ Corp. For a brief time, that target is reached, and the stop-loss order becomes a market order to sell shares at current prices. But suppose there isn’t a standing offer in the market to buy at $50 when it comes time to sell. In that case the investor might get less than $50 if the market order is executed at the current market price. Or suppose the share price plummets to $35 in after-hours trading. The investor might get stuck with much less than their preferred trigger price of $50 when the market opens the next day. 

One way the investor could have avoided selling for much less than the trigger price would have been to use a limit order along with the stop-loss order, perhaps not allowing a sale below $45. That could have protected them if XYZ’s plunge was temporary, but would also leave them exposed to the possibility that the shares could fall even further.

How do investors use stop-loss orders? 

Stop-loss orders can be used to determine a trigger price to sell an investment. They also can be used by investors that can’t or don’t want to monitor prices regularly to set a price at which they will sell an existing investment.

Stop-loss orders often are used to create an exit strategy that will lock in profit for an investment that has appreciated or to set a lower limit on an investment that has fallen. Investors can combine a stop-loss order with a limit order to create a price range where an investment can be sold. 

However, stop-loss orders may not be appropriate in all cases. A long-term investor may be content to hold for years rather than setting up an exit strategy in case the investment falls below a certain point.

What is a trailing stop loss order?

A trailing stop-loss order employs a variable price that can be a percentage or dollar amount higher or lower than the current price of the investment in question. This essentially means that if the price moves in a desired direction, the trailing stop price changes—or trails—the price of the investment by the decided-upon amount. But if the investment’s price movement is unfavorable and it declines, the trailing stop price stays the same, and the order will be executed if the investment’s price hits the trailing stop price. 

For example, an investor buys XYZ Corp. at $100 a share and it rises to $120. They decide to place a trailing stop order to sell with a trailing stop price $5 below the current price. If XYZ Corp. gains $10 to $130, the investor’s trailing stop price now is $125. If XYZ Corp. starts to fall, the trailing stop price remains $125. The investor’s investment in XYZ Corp. will now be sold if shares fall to or below $125. 

The bottom line

Stop-loss orders are used to set a price at which an investment will be sold. They can help investors achieve a variety of goals by setting floor and—in the case of shorting investments—ceiling prices that can limit a loss or lock in a profit.

Stop-loss orders are conditional, and if the conditions aren’t met, the investment won’t be sold. An investor who wanted to make sure that a sale takes place would avoid imposing conditions and instead would use a market order that would be executed at the current market price. 

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