What is a Stop-Loss Order?

A stop-loss order is like a spotter at the gym…

If you’re trying to get stronger in your upper body, you might want to push yourself on the bench press. But pushing yourself to the limit can be dangerous. If your arms give out, you might be stuck with more weight than you can lift sitting on your chest. That’s why you have a spotter. You tell them not to touch the bar unless things go poorly. As soon as your arms give out (the price falls to the stop) that spotter (your broker) will reach in and help you lift it up (sell your falling stock).

In stock trading, there are two basic types of orders you can make. One is called a market order, which tells your broker to pay whatever the going rate is for a stock. Your broker fills your market orders as the next available trade while the market is open.

The other is called a limit order, which tells your broker to buy or sell a stock for you, but only if they can get a specific price or better.

For example, imagine a stock is currently trading at $100 per share, and the price is increasing. You could place a buy market order. You may end up paying, say $101 by the time your trade is processed. Or, you could place a buy limit order at $100. In that case, you are telling the broker that $100 is your limit and not to pay more than that. If the price keeps rising, your trade never gets executed.

A stop order is a conditional instruction. If the price moves past the stop price, it is triggered and converts. In the case of a stop-loss, it becomes a market order. The trade then occurs as soon as a buyer or seller is available while the market is open.

For example, say you placed a sell stop-loss at $95 while the stock is trading at $100. While the price is above $95, the order sits on the sidelines, and nothing happens. The moment the price falls to $95 or lower, a sell market order gets issued.

The broker then treats your stop-loss like a market order that was just submitted. They will sell your stock at the going price as soon as a buyer is located.

There is one more important issue to consider when using a stop-loss. Sometimes, a stock doesn't open at the same price as the previous closing price. Whether because of trading halts or because it’s the end of the trading day, a stop-loss can stay in force while trading is stopped. If trading resumes at a much lower price, your stop-loss may fall in the gap between the closing price and the price where trading resumes. If that happens, your stop-loss will trigger at a much lower price than you may have anticipated.

Most online brokers offer a stop-loss as an option when you enter a sell ticket for a stock you own. All you need to do is choose how many shares to sell and what you want the stop price to be. The stop price of a sell order needs to be below the current market price. Otherwise, it would immediately trigger and become a market order.

The idea of using a stop price is to protect your position from sharp declines. For example, say that you think there’s a risk that a stock you own might drop by 10%. But the price is climbing, and you don’t want to sell right away. You could put a stop-loss in place at 5% below the current price.

If the current price is $100, perhaps you would place a stop-loss at $95. Then, if the stock value really did fall to $90, your stop loss would turn into a market order at $95. But, if the value kept climbing, you could enjoy the ride. The downside of a stop-loss is that it locks in your loss. If a stock has a high beta (the price moves up and down a lot), you could trigger the sale and miss out on the rebound.

Recall that $95 stop-loss you placed on your $100 stock. What if the price dipped to $94.99 and then shot up to $110 in the matter of a few hours? You might see the ticker showing a gain of 10% and get excited.

But you might later learn that you ended up posting a five percent loss on the day rather than the 10% gain. And the stock price might have only hit your stop price for a few seconds.

A stop-loss, like a limit order, can last for as long as you want. Commonly, the order will continue until the market closes for the day. Another option is to leave the order in place until it is either executed or canceled (called good ‘til canceled, or GTC).

Some brokers may allow custom effective dates, although that is less common. For example, you may be able to place a stop-loss that expires in 30 days, or at the end of the month.

Is stop-loss legal?

In stock trading, a stop-loss is just an advanced direction to a broker. It simply says that you want to place a trade, but only if the value of a stock reaches a specified price.

Unless the trader is violating the law in some other way (such as by using illegal inside information), the practice of placing stop-loss orders is perfectly legal.

The difference between a stop-loss and a stop-limit appears when the stock price hits the stop. With a stop-loss, the order becomes a market order. With a stop-limit, the order becomes a limit order. The implications of becoming a market order versus a limit order can be significant.

With a market order, your broker executes your trade as quickly as possible. They get you the best price they can, but they don’t sit around waiting for the price to improve. A market order gets traded at the market price. And that market price could change significantly between the time the stop loss is triggered and the time it is filled.

In fact, a sell stop-loss order might get filled at a price far below the stop price. That’s possible if the stock’s price falls very quickly. Or a buy stop-loss might get filled above the stop price, if the price is rising fast.

With a limit order, your broker executes your trade only if they can ‘beat’ your limit price. For example, if you place a buy limit order at $100 while the price is rising, the limit order tells the broker not to pay more than $100. If they can’t, the request remains unfilled rather than paying the higher rate. If you place a sell limit order, the broker won’t accept a price below your limit.

Now, consider what happens if you place a sell stop-limit order intending to limit your loss. You own a stock currently trading at $100. You submit a stop-limit order with a stop price of $95 and a limit price of $94. Then the price begins to fall. Imagine it opens the next day at $93.

Your stop-limit order becomes a sell limit order, with a limit price of $94. Because your minimum acceptable price is $94, your broker doesn’t sell. The price keeps falling. Maybe it gets down to $90, and you don’t know why your order didn’t stop your losses.

When the stock price starts climbing again, your limit order might still be in effect. When it reaches $94, your broker sells your stock. If that wasn’t the plan, you probably intended to place a stop-loss. A stop-limit doesn’t always achieve the same thing.

However, a stop-limit order might make sense if you have a floor price that you are willing to sell the stock for. Perhaps you believe the company is worth $90 per share just based on its assets. If the price fell below $90, you would rather keep the stock then sell it.

This situation is perfect for a stop-limit order. You might set the stop price at $95 to limit your loss. But you would also tell your broker not to sell it for less than $90 if the price keeps falling.