What is a Stop Loss?
By Mike Tibbits, YouCanTrade
A stop loss is a type of order that is placed to exit a trade once the value of the position reaches a certain amount of loss. Stop losses are mainly used as an attempt to limit risk using a predefined set of rules that reduce the potential for an undefined amount of loss.
For example, let’s say you buy a stock at $50 per share. Ideally, you’d like the value to go higher, but you may not want to risk losing more than 10 percent on the trade. You could set a stop loss to exit the position if the stock’s value drops to $45 per share or below. If the stock never falls to $45, then you will remain in the position until you decide to exit it. However, if the stock reaches $45 or below, your stop loss will trigger a sell order.
There are two kinds of stop loss orders:
The first stop loss order is called a stop market order. A stop market order is just like a regular market order, except that it is only activated when the stock price reaches your stop price. In our example, the stop price is $45 per share. The stop price acts as the trigger to send the sell market order.
Note: A market order just means that your order will be filled at the current market price.
The other type of stop loss order is called a stop limit order. Again, this order gets activated when the stock price reaches your stop price – $45 per share in our example. The stop price acts as the trigger to send the sell limit order. Unlike market orders, however, in addition to setting a stop price, you are setting a limit, and a limit order will only get filled at a specific price or better.
Stop limit orders carry the risk of not being filled because, once triggered, for your order to get filled, the market must be at the desired price or better. If the market continues moving away from the desired price, your order will not get executed.
Going back to our example, if our stop price is $45, and the stock gaps down from $50 to $45, the sell order is trigger. If we use a stop limit order and set the sell limit at $45 per share, this means that once the stop triggers the sell limit order, the market will need to trade at $45 or higher for the order to be filled. If, in our case, the stock continues to fall below $45, the stop limit order will not be executed.
Applying stop losses to short trades:
Stop losses can also be applied to short trades. Short trades are those in which you sell an asset you do not own because you think that the value of the stock will go down. To sell short, you borrow the shares, but you must ultimately buy the shares back. Someone who is shorting a stock is doing so in hopes that the stock can be bought back for a lower price.
Stop losses for short trades include buy stop market orders and buy stop limit orders. They work the same way as the stop market and stop limit orders that we went over, except that they are buy orders instead of sell orders. This is because, to close a short trade (also known as covering a short position), you must buy back the shares you borrowed, and you do that with a buy order.
Going back to our original example, instead of buying the stock at $50, you sell it at $50, hoping that it will drop in price. In that case, you might place a stop market order at a higher stock price than you sold it, limiting your risk if the stock increases in price instead of decreasing in price (since you want the price to decrease if you sold the stock short). If you set the stop price at $55, if the stock hits $55, your buy order will be triggered, and a market order will be placed for the purchase of the stock at the market price. If you use a stop limit order at $55, once the stock hits $55, your buy order will be triggered but only for a price of $55 or lower, which means it will only be filled if the market doesn’t continue to drive the stock price up.
Overall, stop losses are a tool that can help a trader set a predefined amount of risk for any given trade. However, be mindful that the market can always gap over a stop loss from one day to the next and the position should still be monitored.
For more information about trading and investing, subscribe to the All Access Pass. With the All Access Pass, you get the perks, benefits and services of every premium channel. Join the YouCanTrade coaches as they trade stocks, options and futures live in real time with real money. Learn more.