How Do I Place a Stop-loss Order?

What is a stop loss?

A stop loss order is an instruction to kill (end) a trade once a specific target is reached or exceeded. As the name suggests, the price a trade stops at is below the amount you paid. When youre making a loss, the trade gets stopped. The counter to a stop loss order is a take profit order. With a take-profit order, the trade is stopped once you make a certain amount of profit.

Stop loss order vs. stop limit order

Its important to explain the subtle difference between stop loss and stop limit orders.

A stop loss is an order that contains an instruction to buy (or sell) a security once its price reaches a certain point (i.e. a price lower than the amount you paid).

A stop limit is an order with two specific price points that have to be met.

The main difference between the two orders is the level of specificity. A stop loss order allows you to set a percentage loss. For example, you could set the stop loss to 10%. If the price of a security falls 10% or more from the price you paid, the order is cancelled.

A stop limit order requires you to define:

• The stop: the bottom line i.e. the point at which the loss limit starts
• The limit: the top end of the price target
• The time frame: this determines how long the limits are active for

A stop limit order could look like this:

• Stop = 1.25
• Limit = 1.26
• Time frame = 1 day

This means a trade will be stopped if the price hits 1.25 to 1.26 within a day. Having this level of control is great, but it can also lead to problems because the order is only executed if the prices are met. Essentially, the stop loss is conditional. If the price drops but doesnt hit the specified stop or limit, the order continues.

Let‘s say you placed the stop loss order when the price was 1.29. When trading starts the following day, the price opens at 1.22. You’re currently making a loss. However, because the price (1.22) isn‘t within your stop limit range, the order remains live. Why? As we’ve said, the order will only end once a specific price has been reached.

In contrast, if you placed a stop loss order and the price opened at a point within the range you‘d set, it would be closed. What you’ve got here is a situation where stop loss and stop limit orders can manage risk. Stop loss orders allow you to set a more general range and are, therefore, more flexible. Stop limit orders are more specific and, therefore, rigid. Both can be useful, so you need to choose the most appropriate one for your needs and level of experience.

Stop loss order example

To make sure you fully understand what a stop loss order is, heres how one could look:

Security = stocks

Company = Amazon

Position = buy

Price = $100

Amount = 1

Stop loss = 10%

Based on the above variables, youre buying one share in Amazon for $100. The stop loss is 10%. So, if the price of Amazon shares drops to $90 or less, the order is automatically closed. Why is the limit $90? Because 10% of 100 is 10:

100 x 0.1 = 10

100 – 10 = 90

In general, stop loss orders are used when you buy a security, i.e. you take a long position (going long means you want the price to increase in value). In this situation, the order gets closed once the security is sold. The broker/brokerages software will sell your security at the best available price once your predefined amount of loss has been reached.

It‘s also possible to use stop loss orders when you sell. In this situation, your sell order is closed by the broker/brokerage’s software placing an offsetting purchase, i.e. the purchase cancels out the sell order. Using stop losses for sell orders (aka short positions) might not be as common, but its something you can do.

Why use stop loss orders?

Stop loss orders are a way to manage risk. The truth is that you cant eliminate all risk from trading. The financial markets are unpredictable. That means you can make a profit or lose money on a trade. However, experienced traders know that you can manage risk by controlling certain variables.

For example, you can carry out technical analysis before you take a position. You can read company reports and assess insights from experts before buying/selling stocks. You can only execute trades with money you can afford to lose. That doesn‘t mean you will lose money or that you want to lose it. However, the money you use for trading should be expendable so that, if the worst happens, it won’t significantly affect your life.

These things give you more control over your trades and help to manage risk. Stop loss orders are another way of controlling the way you trade. These orders don‘t stop you from losing money. What they will do, however, is limit your losses. You won’t lose more than expected because, as weve said, an order gets closed once the specified limit is met/exceeded.

How to Set Stop-Loss Orders?

Most online brokers offer a stop-loss as an option when you enter a sell ticket for a stock you own. All you need to do is choose how many shares to sell and what you want the stop price to be. The stop price of a sell order needs to be below the current market price. Otherwise, it would immediately trigger and become a market order.

The idea of using a stop price is to protect your position from sharp declines. For example, say that you think there‘s a risk that a stock you own might drop by 10%. But the price is climbing, and you don’t want to sell right away. You could put a stop-loss in place at 5% below the current price.

If the current price is $100, perhaps you would place a stop-loss at $95. Then, if the stock value really did fall to $90, your stop loss would turn into a market order at $95. But, if the value kept climbing, you could enjoy the ride. The downside of a stop-loss is that it locks in your loss. If a stock has a high beta (the price moves up and down a lot), you could trigger the sale and miss out on the rebound.

Recall that $95 stop-loss you placed on your $100 stock. What if the price dipped to $94.99 and then shot up to $110 in the matter of a few hours? You might see the ticker showing a gain of 10% and get excited.

But you might later learn that you ended up posting a five percent loss on the day rather than the 10% gain. And the stock price might have only hit your stop price for a few seconds.