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How Stop Loss Orders Work

Many seasoned investors and traders follow the mantra “ride your winners and sell your losers fast” .  This is for good reason as stocks tend to be slow to rise, but quick to fall.  To mitigate the risk of stocks dropping quickly, many investors use Stop Loss orders to automatically reduce losses or protect their gains.

What is a Stop Loss Order?

A stop loss order is a “sell” order but will only be executed under certain conditions defined the by investor.  This type of order is typically used to minimize losses while holding onto a stock position.

Stop Loss Market Order

Clicking the “sell” button, and selecting the “stop” order type is a stop loss market order.  Once the stop price is set, the broker will execute the sell market order once the stop price is reached.

For example, say you own 100 XYZ shares @ $10 and would like to set a stop loss order for $9.  Once the sell order is set, it will only execute once XYZ reaches $9 at which time it will sell as a market order.  The advantage of a market order is that the sell order will execute and fill.  The downside is that your sell order is subject to “market” prices, which can potentially be much lower than your stop price.

Stop Loss Limit Order

A stop loss limit order is slightly different than the stop loss market order.  When “stop limit” order type is selected both a “stop price” and the “limit price” is entered.  Once the stop price is reached, the brokerage will execute a “limit” order at the predetermined limit price.

Using the same example above with 100 XYZ shares @ $10, a stop loss order of $9 and now a limit order of $8.90.  In this case, once the sell order is set, it will only execute once XYZ reaches $9 AND there is a buyer @ $8.90.  The advantage of this is that you have set a limit on your sell price, which removes the risk of selling at market which can potentially be much lower.  The disadvantage is that the stop loss order may never be filled if it cannot find a buyer @ $8.90 thus defeating the purpose of downside protection.

Trailing Stop

What about the scenario where the stock price is rising, you want to let the stock run, but you don’t want to give back all your gains in case the stock starts to turn over.  In this case, you can use what’s called a “trailing stop” order which will set a stop order when your position falls a certain percentage or dollar amount.  The trailing stop will set a new stop price as the stock rises, but will trigger the order if it falls by the stop percentage or amount.

Keeping with the same example with 100 XYZ shares @ $10 but in this case, the stock is rising fast.  Say that it makes it to $15 and you want to let it ride, but you don’t want to give back all your gains.  To set a trailing stop, you can either choose a percentage or a dollar amount, as well, as a market or limit order.  Say that you would like to sell if the stock drops by 10%.  Once you set that percentage in your discount broker trading interface, it will execute a stop order if the stock falls to $13.50 (10% x $15).   If the stock continues to rise, it will automatically adjust the stop price upwards according to the set percentage or price.

Final Thoughts

Setting stops can be useful for traders, but for long term investors it may lead to prematurely exiting your position.  For traders who have a set amount of risk per trade (maximum loss amount), then setting a stop may be a disciplined way to sell your losses early.  Or alternatively, if your stock position has risen significantly, a loose trailing stop is useful to help ride and maintain your gains.

Back to you, do you use stop orders?

 

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FrugalTrader About the author: FrugalTrader is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 13 comments… add one }
  • Ed Rempel June 10, 2013, 12:17 pm

    Hi FT,

    I get a kick out of stop losses. In my opinion, they are a technique marketed to amateurs to artificially increase trading.I don’t think stop losses make any sense at all.

    The reason is that stock prices are not serially correlated, which means that a stock that just fell 10% (or whatever amount you set for the stop loss) is just as likely to rise or to fall as a stock that has not fallen.

    The idea that you want to automatically sell a stock if it falls say 10% makes no sense to me. If an investment falls, I would want to evaluate why and decide whether to hold, sell or more likely buy more.

    To me, sell orders should be at market or higher than market – never lower.

    The belief that a stop loss protects you is also false, as many investors found out in the “flash crash”. Once a stock falls below your stop loss, your sell order becomes a market order and your stock is dumped. In the flash crash, some investors with a 10% stop loss sold their stock for a 30% loss on a day when the market was flat.

    When I talk with top fund managers, they don’t use stop losses. Studies I have seen (I’m trying to remember where.) show what is logical – investors that use stop losses tend to have lower returns than those that don’t. Their stock picks tend to be similar, but they just take losses more often.

    In my opinion, if you think you need a stop loss on an investment, then you have no confidence in that investment so you should not buy it at all.

    I think stop losses are badly named. They should be called “Take Losses”. :)

    Ed

  • Sarlock June 11, 2013, 3:47 am

    I concur. I don’t use stop losses, though I also do check the market several times a day to see how my positions are performing. Stop losses can end up making you exit a stock during a short moment of weakness and as you mention, Ed, you may end up selling for significantly lower than your stop loss by the time the market completes your trade: the professionals are making the money on your panic sale.
    Unless there is a dramatic change in fundamentals for a company, I find that most serious drops in share price due to some bad economic or company-specific news tend to recover at least partially by the end of the trading day. Selling during the trough may set you 5-10% behind where you would have been had you just held on instead.

  • Thomas June 11, 2013, 10:15 am

    SLO bit me in the butt once and I never did it again. Sometimes stocks have a bad morning and bounce later in the day. Stop loss will have you selling and possibly missing out on the up tick. I would say that if you already have a good profit and didn’t take any off the top I would put in a stop so you don’t lose your gains. I don’t do it since I usually sell off and buy on the pull back.

  • SST June 11, 2013, 11:39 am

    *”I also do check the market several times a day to see how my positions are performing.”

    *”Sometimes stocks have a bad morning and bounce later in the day.”

    It’s comments such as these where people have to realize (hopefully) that buying stocks is NOT buying the underlying company. What you are speculating on first and foremost is the stock MARKET, which, as pointed out, is subject to a myriad of influences, both positive and negative, which may or may not be company related.

  • Al June 11, 2013, 1:54 pm

    Buying a stock IS buying a proportionate stake in the underlying company.

    The stock market is a forum where buyers and sellers meet and set the price of stakes in various companies, they do not however set the value of that stake.

  • Sam June 11, 2013, 5:37 pm

    Hey FrugalTrader

    Out of curiosity, what broker do you use now for your registered accounts and non registered? Do you find execution for these orders better at either one?

    • FrugalTrader FrugalTrader June 11, 2013, 7:48 pm

      @Sam, unfortunately, I have too many discount broker accounts! Between my wife and I, we have accounts with Questrade, CIBC Investors Edge, Interactive Brokers, and Scotia iTrade. To answer your other question, I do not notice a difference with execution time. The quickest may be IB as they have direct market access.

  • Sam June 11, 2013, 9:12 pm

    Hey FT

    Thanks for the response. May I follow up with a why? Isn’t it a lot harder to manage one portfolio? Is there a reason to keep any of the others when you have IB and large banks.

    I’m only asking becasue I’m looking to make the switch from QT and IB and doing my research online landed on this site :) It seems to me that IB tops QT in every respect. I hold my registered accounts at TDW was looking whether I should move my non registerred account from QT to IB.

    Any input is appreciated, would help ease my decision.

  • FrugalTrader FrugalTrader June 11, 2013, 9:19 pm

    @Sam, that’s a good question! I opened IB a number of years back for trading purposes (b/c of their low fees), but I dont’ use them much anymore except for FX (super low fees). CIBC, I opened when i was younger and have kept the account. I opened Questrade for my wife b/c of the low fees and RRSP USD accessibility.

    But you are right, less is more. I can’t really complain about IB except that they charge a mandatory $10/month fee and that hey charge extra for data feeds. If you trade often, the fees are unbeatable (providing you don’t trade penny stocks).

  • Brian June 12, 2013, 5:39 am

    It’s called a “guaranteed” loss. Stay far away from any of this stuff.

  • I buy and hold and have no plans to change until 3 to 5 years out from retirement. I will drop an occasional dog but other than that I think prices rise over the years.

  • Investor Trip June 15, 2013, 2:54 pm

    Yep. Stop loss orders take a lot of risk out of investing. People don’t know they can lock in gains or limit losses with a few button clicks. Trailing stops are Awesome because they give you room of marginal error. Investing becomes automated but people get afraid of the “risk.” There is little risk if you know what you are doing!

  • Brian June 16, 2013, 2:09 am

    HAHAHA… yeah, they certainly remove some of they risk. They absolutely guarantee losses.

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