What is a stop-loss order? How to manage risk in trading

What is a stop-loss?

A stop-loss order is an instruction to sell (for a long position), or buy (for a short position) if the price reaches a specified level, to help limit losses. For long positions the stop price is typically below the entry price; for short positions it is typically above. When you’re making a loss, the trade gets stopped. The counter to a stop-loss order is a take-profit order. With a take-profit order, the trade is stopped once you make a certain amount of profit. 

It’s important to understand that stop-loss orders help manage risk but do not guarantee the execution price. In fast markets you may be filled at a worse price (slippage), and stop-limit orders may not execute. 

Stop-loss order vs. stop-limit order 

It’s important to explain the subtle difference between stop-loss and stop-limit orders.

A stop-loss is an order that contains an instruction to buy (or sell) a security once its price reaches a certain point (i.e. a price lower than the amount you paid). 

A stop-limit is an order with two price points: a stop price that triggers the order, and a limit price for the order placed after it triggers. 

The main difference between the two orders is the level of specificity. A stop-loss order allows you to set a percentage loss. For example, you could set the stop-loss to 10%. If the price of a security falls 10% or more from the price you paid, the stop-loss triggers and the position is closed by executing an order (subject to market conditions). 

A stop-limit order requires you to define: 

• The stop: The bottom line (i.e. the point at which the loss limit starts). 
• The limit: The top end of the price target. 
• The time frame: You can also set a time-in-force (how long the order remains active). 

A stop-limit order could look like this: 

• Stop = 1.25 
• Limit = 1.26 
• Time frame = 1 day 

This means the stop-limit order is triggered if the price reaches 1.25; it will then place a limit order at 1.26 (or better), subject to market conditions and liquidity. Having this level of control is helpful, but it can also lead to problems because the order is only executed if the prices are met. Essentially, the stop-limit order is conditional. If the stop price is triggered but the market cannot trade at the limit price (or better), the limit order may not execute and the position may remain open. 

Let’s say you placed the stop-loss order when the price was 1.29. When trading starts the following day, the price opens at 1.22. You’re currently making a loss. However, because the price opened below your stop price, the stop-limit would trigger, but the resulting limit order at 1.26 may not execute (so the position may remain open). Why? As we’ve said, the order will only end once a specific price has been reached. 

In contrast, if you placed a stop-loss order and the price opened at a point within the range you’d set, it would be closed. What you’ve got here is a situation where stop-loss and stop-limit orders can manage risk. Stop-loss orders allow you to set a more general range and are, therefore, more flexible. Stop-limit orders are more specific and, therefore, rigid. Both can be useful, so you need to choose the most appropriate one for your needs and level of experience. 

Stop-loss order example 

To make sure you fully understand what a stop-loss order is, here’s how one could look: 

Security = stocks 
Company = Amazon 
Position = buy 
Price = $100 
Amount = 1 
stop-loss = 10% 

Based on the above variables, you’re buying one share in Amazon for $100. The stop-loss is 10%. So, if the price of Amazon shares drops to $90 or less, the order is automatically closed. Why is the limit $90? Because 10% of 100 is 10: 

100 x 0.1 = 10 
100 – 10 = 90 

In general, stop-loss orders are used when you buy a security, i.e. you take a long position (going long means you want the price to increase in value). In this situation, the order gets closed once the security is sold. The broker/brokerage’s software will sell your security at the best available price once your predefined amount of loss has been reached. 

It’s also possible to use stop-loss orders when you sell. In this situation, your sell order is closed by the broker/brokerage’s software placing an offsetting purchase, i.e. the purchase cancels out the sell order. Using stop-losses for sell orders (aka short positions) might not be as common, but it’s something you can do. 

Why use stop-loss orders? 

Stop-loss orders are a way to manage risk. The truth is that you can’t eliminate all risk from trading. The financial markets are unpredictable. That means you can make a profit or lose money on a trade. However, experienced traders know that you can manage risk by controlling certain variables. 

For example, you can carry out technical analysis before you take a position. You can read company reports and assess insights from experts before buying/selling stocks. You can only execute trades with money you can afford to lose. That doesn’t mean you will lose money or that you want to lose it. However, the money you use for trading should be expendable so that, if the worst happens, it won’t significantly affect your life. 

These things give you more control over your trades and help to manage risk. Stop-loss orders are another way of controlling the way you trade. These orders don’t stop you from losing money. Stop-loss orders can help limit losses, but they don’t guarantee the execution price. In fast markets or price gaps, the fill can be worse than the stop price (slippage), and stop-limit orders may not execute. 

Stop-loss orders aren’t always appropriate 

Keep in mind that, sometimes, stop-loss orders can be problematic. For example, in highly volatile markets, stop-loss orders aren’t always advisable. This is because prices can rise and fall dramatically in a short time. 

Let’s say you’ve set a stop-loss of 10% and you’re buying securities in a volatile market such as forex. The price of a security could drop 10% and, a minute later, increase in value by 15%. These swings can happen and they’re something people who trade in volatile markets accept. Using a stop-loss order in these conditions will protect you from the dramatic downswings, but they’ll also prevent you from riding the upswings. 

This doesn’t mean using stop-loss orders in volatile markets is a bad idea. You shouldn’t implement this risk management tool without considering the bigger picture. It might be suitable for the current conditions, but it might not be. Whether it is appropriate depends on the instrument, market conditions, and your financial goals.

Trade online with stop-loss orders 

Before you head into a live trading market and use this tool, we suggest using a broker’s demo software. When you create a demo account, you receive a virtual bankroll. This bankroll can buy and sell securities and you can also use it to place stop-loss orders and get a feel for how they work. 

Once you’re comfortable placing these orders and how the financial markets work in general, you can switch to a live account. Stop-loss orders can help you manage risk when you trade, but they cannot prevent losses.