Stop Loss
A stop-loss order is a type of conditional order in financial trading that automatically closes a position when the asset reaches a specified price.
Purpose:
- To limit potential losses on a trade.
- To protect capital from significant decline.
- To manage risk and avoid catastrophic losses.
How Stop-Loss Orders Work:
- Setting the Stop-Loss Price: The trader specifies the stop-loss price at a certain level below the entry price.
- Triggering the Order: If the asset price reaches the stop-loss price, the order is executed, closing the position at that price.
- Exit at Stop-Loss: The position is exited at the stop-loss price, regardless of whether the trader has manually placed an order to close it.
Types of Stop-Loss Orders:
- Market Stop: The order is executed at the best available price in the market at the time of triggering.
- Limit Stop: The order is executed at the specified stop-loss price if it becomes available in the market.
- Trailing Stop: The stop-loss price is moved along with the asset price when the asset moves in your favor.
Advantages:
- Provides a clear exit point in case of a loss.
- Limits potential losses.
- Can help manage risk.
Disadvantages:
- May not be able to get the best possible price if the market moves rapidly against you.
- Can be emotionally difficult to see your position closed against your will.
- May not be suitable for complex trading strategies.
Best Practices:
- Place stop-loss orders with enough buffer to account for market volatility.
- Use trailing stop-loss orders to lock in profits as they increase.
- Review stop-loss orders regularly to ensure they are still active.
- Consider the overall risk tolerance and objectives of your trading strategy when setting stop-loss prices.
Example:
You buy an asset for $100 and set a stop-loss order at $90. If the asset price drops to $90, your stop-loss order will close the position at that price, limiting your potential loss to $10.
FAQs
What is a stop-loss?
A stop-loss is an order placed with a broker to sell a security when it reaches a certain price, designed to limit an investor’s potential loss on a position.
How does a stop-loss work?
When the security price hits the stop-loss level, the stop-loss order triggers, selling the asset at the next available market price, thus helping limit further loss.
What is the 7% stop-loss rule?
The 7% rule suggests selling a stock if it drops 7% below the purchase price, which helps protect against large losses in volatile markets.
What are the disadvantages of a stop-loss?
Stop-loss orders can trigger prematurely during market fluctuations, causing an investor to sell at a loss even if the price later rebounds. They can also lead to unexpected sales in highly volatile stocks.
How do you calculate a stop-loss?
To calculate a stop-loss, set it at a percentage below the entry price, often based on risk tolerance. For example, if you buy at $100 and set a 10% stop-loss, your stop-loss would be $90.
