When it comes to buying and selling stocks, investors have several options, including using techniques involving stop loss orders. It's important to understand how this type of order works; because they can limit a loss in a volatile stock market.
In this article, we're going to explain the concept of a stop loss order. As part of that explanation, we're going to provide a simple definition of the term. Next, we're going to run through some examples demonstrating how these orders can limit losses, or preserve gains, in an unpredictable stock market. Finally, we're going to cover the pros and cons for these types of orders.
A stop loss order, also known as a "stop order" or a "stop-market order" is defined as an order placed with a broker to buy or sell a stock when the price of the stock reaches a pre-defined price, which is known as the stop price. Once the price of the stock reaches the stop price, the instruction to buy or sell then becomes a market order.
There are several variations of the stop loss order, each with a considerably different objective:
In the following sections, we're going to give an example for three different order types. Each example should help the investor to better understand how each type of order can be used to protect a gain or to limit a loss.
Investors place sell stop orders when they're concerned that a stock they're holding may drop in value, and they want to limit a loss, or lock in a gain.
In this example, the investor owns a stock valued at $30 per share, and they would like to sell it if the price drops by 10% or more. In this case, the investor issues a sell stop order at $30 minus 10% or $27. If (or when) the stock's price reaches $27, the sell stop order is converted to a market order and the stock is sold at the next available price.
Investors typically place buy stop orders to cover a short sale. Investors that sell stocks short believe the price of that stock is going to decline. If the price declines, then the investor has a right to buy it at the lower price and realize a profit. But if the stock increases in price, then the investor will need to buy it at a higher price.
In this example, the investor places the order at $30 per share, which is above the current market price of $27. If the price of the stock moves above $30, then the buy stop order becomes a market order, and the stock is purchased at the next available price.
Investors will place a trailing stop order if they want to maximize a profit when a stock's price is rising, and limit a loss when its price falls.
In this example, the investor places a trailing stop sell order at $30 per share with a $3 trailing stop, or a stop price of $27. If the price of the stock falls to $28, then the order is not executed because the stop price was not reached.
If the stock's price increases to $40, then the trailing stop order is reset to $40 minus $3 or $37. If the price of the security falls to $37, then the trailing stop order is converted to a market order, and it's sold at the next available price.
There are several important advantages of stop loss orders:
There are also several important disadvantages of stop loss orders:
This last point is an important one because stop loss orders can, and do, contribute to a rapid sell-off of securities during a market crash. In fact, this action is believed to have contributed to the stock market crash of 2008. As the price of stocks began to fall in October 2008, stop loss orders were triggered, flooding the market with sell orders and a surplus of stocks.
When the supply of stocks outpaces demand, prices will continue to decline. This cycle of declining prices and the programmatic triggering of stop loss orders will inevitably add to the steepness of any market's decline.
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