A stop-loss order is a risk management tool used by traders to automatically close a trade at a predetermined price level. It is designed to limit potential losses by exiting the trade if the market moves against the trader’s position.

Why you should use a stop-loss order

When investing to the stock market, implementing a stop-loss order brings advantages such as:

Loss Limitation:

By establishing a predetermined exit point, you can define your acceptable level of risk and ensure that you exit the trade if the market moves against your position. This helps protect your trading capital and prevents losses from exceeding a certain threshold.

Emotion Control:

Fear and greed are enemies to rational trading. By setting a stop-loss order in advance, you remove the need to make impulsive decisions under stress.

Automation and Convenience:

Stop-loss orders are executed automatically when the specified price level is reached or surpassed. This eliminates the need for constant monitoring of the market and manual execution of trades.

How a stop-loss order works

1. Placing the Stop-Loss Order:

When placing a stop-loss order, you specify a stop-loss price, which is the price level at which you want the order to be triggered. This is the price at which you are willing to accept the loss and exit the trade.

2. Monitoring the Market:

Once you have placed the stop-loss order, monitor the market and track the progress of your trade. If the market price reaches or surpasses the stop-loss price, the stop-loss order is triggered.

3. Execution of the Stop-Loss Order:

Once the stop-loss order is triggered, it becomes a market order to close the trade. The trade is then executed at the best available price in the market. The execution price may be slightly different from the specified stop-loss price, particularly in situations of high volatility or market gaps. This is known as slippage.

4. Limiting Losses:

The purpose of a stop-loss order is to limit potential losses on a trade. By closing the trade at the stop-loss price, you exit the position before the losses exceed your predetermined acceptable level. This helps protect your trading capital and manage risk.

5. Flexibility and Adjustments:

You can adjust your stop-loss orders as the market moves to protect your profits or further limit potential losses. This can involve moving the stop-loss price closer to the entry point (known as trailing stop-loss) or adjusting it based on changes in market conditions or your trading strategy.

The Bottom Line

Stop-loss orders are not foolproof. In fast-moving or volatile markets like the penny stock market, the execution price may deviate from the stop-loss price due to slippage. Additionally, stop-loss orders do not guarantee that losses will be limited to the exact predetermined level, especially in situations where market conditions are rapidly changing or liquidity is low.

You should carefully consider market conditions and the specific features and limitations of stop-loss orders offered by your trading platform or brokerage for stocks. Combining stop-loss orders with sound risk management practices and thorough analysis can enhance trading strategies and effectively manage trading risks.