Stop-Loss Order (Trading) - Explained
What is a Stop-Loss Order?
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Table of ContentsWhat is a Stop-Loss Order?How Does a Stop-Loss Order Work?Stop-Loss Order ExampleStop-Loss Order Gapping
What is a Stop-Loss Order?
Brokers use the stop-loss order as an exit strategy, especially when the conditions of a trade are not favorable. A stop-loss order is an order used by a broker to sell a security or an investment instrument when it reaches a certain price limit. Typically, a stop-loss order helps to minimize the loss in a trade, it is used when a broker discovers that the price of a security has dropped to a certain point and can cause significant loss if not quickly sold. Stop-loss orders are commonly used when brokers or investors take long positions in the market, it is a strategy that offset or minimize the loss in a trade.
How Does a Stop-Loss Order Work?
A stop-loss order is otherwise called a stop order or stop-market order. An investor who is unavailable to closely monitor his position in a trade can also use the stop-loss order. As part of the agreement of the trade, such an investor can instruct his broker to sell the stock if it drops in price to a certain limit. Although stop-loss orders are often used for long positions, investors sometimes use it as protection when taking a short position. Due to the volatility and fluctuations of the investment market, investors take several approaches to protect themselves from loss. Stop-loss orders can be efficiently used in orderly markets but when the market is not in order or falls easily, the execution of a stop-loss order might be inefficient.
Stop-Loss Order Example
For instance, if Investor A buys the shares of Apple currently trading at $100 per share, a stop-loss order can be used to protect the shares from a decline in prices. If the investor used the stop-loss order, he could set the stop order price as $98, this means in situations where the shares decline in price, once $98 is reached, the shares must be sold off to prevent further loss. Peradventure, if the shares of Apple drops from $100 to $98, the stop-loss order will have the shares sold at the next available price without any further delay.
Stop-Loss Order Gapping
Stop-loss order gapping can occur and this means an investor might lose further on the position held. When stock or price gapping occurs, the effective execution of a stop-loss order is truncated. From the example sighted above, if investor A closes that shares purchased at $97.50 at the close of the market and makes a report of his earnings, if, by the next day, the stock opens at $94.60, stock gapping has occurred which automatically means the shares will be sold at the next available price of $94.60. Instead of losing $2.50, the investor will now lose $5.40. Due to this drawback on stop-loss orders, investors prefer to use stop-limit orders which allow them to sell a stock at a specified limit price and not at the market price. Investors use the stop-limit order to hedge against further loss they can accumulate if they use the stop-loss order.