Brokerages perform several stock order types to allow clients to buy and sell stocks, including market orders, cover orders and stop-loss orders. The most common order types notify the broker about an investor’s desire to acquire or sell a stock at a particular price (or better). Other order kinds are available for investors who want to reduce their risk of trade losses. Specifically, a stop-loss order is an order that allows an investor to restrict the potential loss on a stock. It does this by by setting a price limit that executes a trade at a specific point.
Stop-loss orders are a financial instrument that allows investors to sell stocks once the stock’s price reaches a specified value. These orders are used by investors to automatically sell when the stock’s price hits the stop-loss order trigger price. A stop-loss can also be used to or buy shares to cover a short position at a determined price point.
Stop-loss: an example
Investors commonly use stop-loss orders to limit their losses on new investments. For example, assume an investor purchases 100 shares of a new IT stock from a firm that has just completed its IPO. And, that firm’s initial public offering was at $25 per share. To prevent the potential loss on this investment the investor can set a stop-loss. For example, the investor could establish the stop-loss for 20% below the purchase price, or $20 per share.
The stop-loss is activated when the price of this red-hot tech stock drops to $20. The investor’s broker then sells the stock at the current market price, which might be at precisely $20 or considerably lower, depending on the stock’s price fluctuations and timing.
Stop-loss orders: the pros
Investors use stop-loss orders to exit stock positions if they do not perform as expected. A stop-loss allows investors to make pre-determined selling decisions and avoid letting their emotions influence their investing judgments.
Other pros of a stop-loss include:
- Brokers do not charge for a stop-loss, making them effectively a free insurance policy to protect against investment losses.
- Regular use of stop-loss orders can help investors become more disciplined about selling losing stocks.
Stop-loss orders: the cons
Stop-loss orders have some drawbacks. First, a stop-loss does not limit an investor’s loss to the difference between the purchase price and the pre-determined sell price. For example, suppose a firm releases disappointing earnings after the market closes. In that case, its share price could be considerably below an investor’s stop-loss value at the start of the next trading day.
Another issue to be aware of with a stop-loss is that it may cause a stock sale even if the price only falls slightly below the trigger point before quickly bouncing back up. If a stock’s price is volatile or something else causes investors to sell briefly, that can activate an investor’s stop-loss.
Finally, skilled investors such as hedge fund operators occasionally attempt to take advantage of the presence of stop-loss orders during severe market downturns. They do this by a process known as stop hunting. Stop hunting is when traders short stocks already on a downward trend to push prices lower and trigger a surge in stop-loss orders. These investors subsequently enter the market to profit from an anticipated recovery by buying those same equities.