Stop-loss order definition
Stop-loss orders enable traders to automatically put up their shares for sale if they fall below a certain price. They can help prevent losses when stock markets begin to decline quickly, and also take the emotion out of trading.
Stop-loss order meaning
Let’s say Bob has bought shares in Amazon for $1,900. He is worried that prices could start to head downwards soon. He can set a stop-loss order that would trigger the sale of his shares as soon as their value dips below $1,850. Although it is not guaranteed that he would receive this price from a buyer, his shares will be sold at the next available price on the market.
Now, let’s imagine that Bob hadn’t set that stop-loss order, and shares in Amazon dipped to $1,600 before he sold them. This would represent a loss of $250 a share.
The pros and cons
Stop-loss orders allow investors to think long and hard about the price they want to sell their shares in advance – eliminating rash and potentially costly decisions. It also prevents the need for shareholders to constantly keep an eye on market movements, as they’ll be safe in the knowledge that action will automatically be taken if prices dip to a point where there is cause for concern.
That said, these tools aren’t perfect. If Amazon was to publish disappointing financial results once the markets have closed, and shares were trading at $1,750 the next day, Bob would have lost an extra $100 a share more than he was prepared to.
In addition, stop-loss orders don’t take into account when prices go up. If Amazon prices were to temporarily soar to $2,500, before returning to $1,850, Bob wouldn’t have realized any of this profit. This is where a trailing stop order can come in handy. Bob can request that his sell price rises in proportion to growth in the stock’s value. If he set a trailing stop order of 10% – meaning that his Amazon shares would be sold when they dipped 10% from their most recent high – his sale would have been triggered at $2,250, $400 more than if he had relied on a stop-loss order alone.