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Stop-Loss: Where & Why?

How to prevent a critical loss on the market

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When you invest, you are either putting your time, money, or another resource into something with the expectation of a benefit of some form. Thousands of people invest their hard earned money every single day. If you’re an active trader, and you fail to set a stop-loss, you run the risk of blowing that hard earned money away. 

What is a Stop-Loss Order?

A stop-loss is a pre-set order placed with a broker to automatically sell a security when it reaches a specific price level, designed to limit an investor’s potential losses. For example, if you bought META stock for $100, and the stock began to fall towards the $70 mark, using a stop-loss at the $90 could have prevented a major loss by selling your share at the $90 level for market price. Although they’re not perfect, they can prevent significant losses.

It is crucial to understand that stop-loss orders are triggered base on the market price, which can fluctuate. In the example above, even though you set the stop-loss at $90, the actual sale might not happen until $85 if the stock price drops rapidly. This means you might not get exactly $90, but the stop-loss still helps limit your potential loss.

What is a Stop-Limit Order?

Stop-Limit orders are very similar to a stop-loss, however, these pre-set orders focus on a specific price for the order to execute. Imagine you own TSLA stock currently priced at $100. You want to limit your downside if it starts dropping, so you set a stop-limit order with a stop price at $90 and a limit price at $88. In this setup, if the stock price falls to $90, your stop-limit order kicks in — but it will only execute if the shares can be sold at $88 or better.

However, if the price falls below your stop-limit, you will be forced into a chasing scenario as the prince attempts to stabilize or find a bottom.

Stop-Loss: The When & Where?

Ideally, you should place either a stop-loss, or a stop-limit order as soon as you open a new trade. You’re going to want to protect your assets as best as you can. The market can change in an instant, reacting to unexpected news, economic reports, or even a large transaction by another trader.

An example of this could be traced during the 2020 market crash surrounding the pandemic. SPY dropped close to a total of 34% for the entire month, making it an extremely volatile time to trade. If just on one of these trading days, you decided to make a long trade, you could have suffered a day trade loss of anywhere between -4% to -10%.

Trailing Stops

You may have heard the phrase “lock in profits” before, without fully understanding its significance in active trading. One way to “lock in profits” is by using a trailing stop strategy. A trailing stop is a type of stop-loss order that moves with the market price.

Suppose you bought GameStop stock at $100 when it started climbing, and you set a $20 trailing stop. As the stock surged to an all-time high of around $483, your trailing stop rose with it, ultimately locking in profits as long as the stock kept rising. When GameStop’s price began to drop sharply from its peak, your trailing stop might have executed around $460, securing significant profits per share.

Frequently Asked Questions

Frequently Asked Questions: Stop-Loss and Stop-Limit Orders

A stop-loss order is designed to sell a security automatically when it reaches a certain price, helping to limit potential losses. A stop-limit order, however, will only execute at the specified price or better, which can prevent the sale if the price falls too quickly and doesn’t meet the limit.

Most stop-loss orders only execute during regular market hours. However, some brokers offer extended hours trading, which may allow for stop orders to be triggered. It’s best to check with your broker for specific policies on after-hours trading.

Most major brokers allow stop-loss orders, though the types available can vary. Some brokers may also have different policies regarding how stop orders are executed, so it’s essential to review your broker’s platform features and guidelines.

Determining the right level for a stop-loss depends on your risk tolerance and the security's volatility. A common approach is to set it 1-2% below the purchase price for stable stocks or 5-10% for more volatile assets. However, each trader should adjust this based on their specific goals.

If your trailing stop executes too early, it could be because your stop is set too close to the current price, making it sensitive to market fluctuations. To avoid this, consider adjusting the trailing distance to a larger percentage, giving the stock more room to move naturally.

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