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A stop-loss order is designed to limit an investor’s loss or protect an unrealized gain on a security position. When a stock reaches a predetermined price, the stop-loss order automatically kicks in, placing a market order to sell the stock (or buy in a short position). The stock is then sold at the best available price, which may differ from the stop price initially set. Stop-loss orders cost nothing to set up and can be helpful for limiting losses if a stock’s price drops unexpectedly.

Here’s how stop-loss orders work, the advantages and disadvantages of using them and the different types of orders.

How a stop-loss order works

A trader places a stop-loss order with a broker to buy or sell a security when it reaches a certain price. The purpose of this type of order is to minimize potential losses by automatically selling the security if its price falls below a certain level or buying a security when it hits a certain price.

The order is set at a particular price, known as the stop price, and becomes active when the stock price reaches that level. At that point, the stop-loss order becomes a market order and the stock is sold at the best available price, which may differ from the stop price. Investors can help manage risk and limit losses with this type of trading strategy.

A stop-loss can be used to limit an investor’s downside risk in a particular investment. You may use this to protect a nice gain or to quickly exit a position that begins moving lower. — Greg McBride | Bankrate Chief Financial Analyst

Example of a stop-loss order

Here’s an example to illustrate the concept of the stop-loss order. Let’s say you buy XYZ stock at $50 per share and want to limit your loss to 10 percent. You could place a stop-loss order with your broker to sell the shares if the price hits $45.

If the stock falls to $45, the order triggers and becomes a market order. The sale will be executed at the best available price, which might not necessarily be $45 if the stock price falls rapidly. If the order does execute at $45, you would have a loss of 10 percent.

Trailing-stop orders

Another type of stop-loss order is called a trailing-stop order. With this type of order, an investor sets a defined percentage or price above or below the current market price. If the market price of the security moves in a favorable direction, the trailing price follows and adjusts by the specific amount. If the market price doesn’t move favorably, the trailing price stays fixed and a market order is triggered if the stock price hits the trailing stop price.

Let’s go back to the previous example. You buy XYZ stock at $50 and set a trailing-stop order for $5 below the market price. If the stock hits $45, a sell order is triggered. However, say the stock rises to $55. The price on the trailing-stop order would rise to $50, meaning if the stock declines from $55 to $50, the order will trigger to sell the stock. If the stock continues to rise, then the trailing-stop order will continue to ratchet higher, either until it is triggered or the order’s validity runs out on a good-til-canceled order, often three months.

The trailing-stop order adjusts your stop price and automatically protects your stock against further loss on a rising stock.

Advantages of stop-loss orders

Here are some reasons to consider adding stop-loss orders to your investing strategy:

Limits losses
In a way, a stop-loss order is essentially a free insurance policy. If a stock’s price drops unexpectedly, a stop-loss order will help limit your losses.
No cost to implement
There is no fee or charge to place a stop-loss order. The only fee incurred is if the stop price is reached and a market order occurs, which may result in a transaction fee.
Controls the price
Investors can help control the price at which the order will be executed and set it as low or high as they want. While you may need to sell at a different price than you want (see slippage in the next section), you may be better off than an investor who didn’t set any sort of stop order.
Gives time back to an investor
Investors who are busy with other responsibilities can set the order and move on, knowing that the order will be in place to hopefully help prevent losses. Stop-loss orders can help prevent investors from monitoring stocks daily and reacting emotionally to a price movement. Having a strategy that includes stop-loss orders provides a plan to exit losing positions.

Disadvantages of stop-loss orders

Stop-loss orders have a few risks to consider. Here’s what to keep in mind:

Market fluctuation and volatility
Stop-loss orders may result in unnecessary selling or buying if there are temporary fluctuations in the stock price, especially with short-term intraday price moves. Greg McBride, Bankrate Chief Financial Analyst, says, “Be thoughtful about how and at what point you institute a stop-loss order, as it could easily be triggered by a short-term overreaction in the stock price that may not be indicative of deteriorating fundamentals. In this instance, the price might quickly recover but you would be out of the position when that happened.”
Stop-loss orders can be subject to slippage, or the difference between the price at which the order is triggered and the actual price at which it is executed, especially in a highly volatile market or on a thinly traded stock. Because a stop order becomes a market order once the stop price is reached and it’s not instantaneous, the actual price at which you sell or buy may differ from the original stop price.
No guaranteed profits
A stop-loss order will not ensure that you make money on a trade.
Not always available
Stop-loss orders may not be available on certain stocks, and some brokers do not allow this type of order to be placed on certain securities.

What is the difference between a stop-loss order and a stop-limit order?

Stop-loss orders and stop-limit orders are both used to control losses in trading. While stop-loss orders trigger market orders when a specific price is reached, stop-limit orders trigger limit orders at that price.

The main difference between these two order types is that a stop-limit order guarantees the order will execute only at the specified price or better while a stop-loss order might execute above or below the original price. This is because a stop-loss order triggers a market order, which trades at the best available price, which might be different from the stop-loss price, as explained above in the slippage section.

Bottom line

Stop-loss orders can be a tool for investors to help limit their losses in the stock market, but they’re not a silver bullet that can help in all situations. For the best results, investors should  be aware of the different order types and understand how they can be used to maximize profits and limit losses.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.