Stop loss orders can be a great tool for investors to utilize in many market situations. When used properly they can be integrated into any strategy and help to automate the selling process.
Most discount brokers do not charge extra for this type of order making them more attractive to the average retail investor.
What Are Stop Loss Orders?
Stop orders work like insurance so that in case the trade goes sour for whatever reason the investor will have his or her position automatically sold for a loss.
In stock market terms this means that if an investor holds 100 shares of company XYZ at $100 per share and they don’t want to lose more than 10% of their investment, then a stop loss order will automatically sell their shares for them if XYZ falls below $90 (10% of $100) at any time. Thus, putting a cap on their losses.
Types of Stop Orders
There are two types of stop loss orders, stop market orders and stop limit orders.
Stop market orders will automatically sell the shares allotted at "the market" once the order is activated. If the stop price is $50 a share, then as soon as the stock hits this pre-set price a market order will immediately be placed to sell the desired position (read more on market orders).
Stop limit orders will automatically place a limit order whenever the trigger price is hit. When placing a stop limit order, the investor needs to also figure out what limit order they want. Setup for more experienced investors, it offers more control over the ultimate sell price of the position but is coupled with more risk.
Reasons to Use Stops
6 reasons for investors to utilize stop loss orders:
1. Insurance against losses. The primary reason investors take advantage of stop loss orders is to insure themselves against losses in a given position.
2. Automation of trading. Investors do not have to be present for a stop loss order to be triggered.
3. Promotes disciplined investing. By sticking to an overall strategy investors can become more consistent and successful in the long run. Minimizing potential losses every trade is one important piece of the puzzle.
4. Keeps things simple. Just like the "set it and forget it" oven stop loss orders keep part of the sell aspect of trading to a basic minimum.
5. Removes market emotions. No trader will be successful in the long haul with emotions in play. Stop loss orders can remove emotions altogether by acting as a "set in stone" strategy.
6. Flexibility of position management. Maximize losses at 2%, 5%, 10%, etc. and for advanced traders the use of stop limit orders gives even more options for how to play a position if the stop loss is triggered.
For the reasons above stop loss orders can be a great tool to take advantage of to not only simplify the trading process but remove emotions and help investors stick to a preset strategy. By capping the downside profit vs loss ratios can be setup for future success.
One Word of Caution
While stop losses are a great tool, they also can be dangerous if a stock decides to "trade through" an investor's live stop loss order. "Trading through" means that the stock did not hit the preset stop loss price to trigger the order to sell, resulting in the stock continuing to fall without the investor knowing.
This commonly occurs when a stock "gaps" down (further explanation) after the market close because of earnings or similar news. If a stock closes at $100 a share with a stop loss at $99 but opens the next morning at $95 because of earnings the investor still holds their full position. Thus, it is important to check up on a position once or twice a day to avoid this dilemma.