What is a Stop Loss in Trading? Why It’s Important and How to Use

Stop losses are a trading must have, whether you are an active trader or long term investor. Understanding how stop loss works will protect your portfolio from big losses.

What is a Stop Loss?

A stop loss is a risk management tool that sells a security when its price hits a certain price level, called the stop price. It allows you to limit your losses by getting out of a position before it goes further down.

Stop Loss Features

• Stop Price: The price level at which the order is triggered.
• Market Order: Once triggered, the stop loss becomes a market order, executed at the prevailing market price.
• Purpose: To limit losses in volatile markets or unexpected price drops.

How does a Stop Loss work?

1. Set the Stop Price: A trader sets a specified price below the current market price.
2. Order Activates: If the stock price hits or goes below the stop price.
3. Execution: The stop loss becomes a market order, selling the asset at the current market price.

Types of Stop Loss Orders

1. Stop Loss Market Order

• Mechanism: Sells the security at the next available market price once the stop price is hit.
• Pros: Trade will be executed.
• Cons: May not get the exact price due to market gaps.

2. Stop Limit Order

• Mechanism: Combines stop loss with a specified stop price and a limit price, so the security can’t be sold below that price.
• Pros: Price control.
• Cons: Won’t execute if the market price goes below the limit price.

3. Trailing Stop Order

• Mechanism: Adjusts as the price moves in your favor, with the stop loss activating at the trigger price.
• Pros: Locks in profits.
• Cons: Can trigger early in volatile markets.

Stop Loss Examples

1. Simple Stop Loss Example

• Scenario: A trader buys Apple Inc at $150 and sets a stop price of $140.
• Outcome: If Apple’s stock falls to $140, the stop loss triggers and sells the shares to limit losses.

1. Trailing Stop Example

• Scenario: A trader has shares of Google Inc with a trailing stop set at 10%.
• Outcome: If the stock goes from $100 to $120, the trailing stop moves to $108. If the price goes below $108, the order executes.

Why use a Stop Loss?

1. Risk Management

Protects against big losses in volatile markets or bad news for the stock.

Many retail investor accounts use stop-loss orders to manage risk and protect their investments.

2. Emotional Discipline

• Automates the trade, so you don’t make impulsive decisions in high risk situations.

3. Across Asset Classes

• Applies to stocks, forex and CFDs so it’s a tool for managing multiple portfolios.

7% Stop Loss Rule

This rule involves selling a stock if its stock’s price drops 7% from the purchase price.

• Example: A trader buys a stock at $100. If the price goes to $93, the stop loss order triggers.
• Reason: Prevents big losses while allowing for small market movements.

Pros and Cons

Pros

• Automates Risk Management: No constant monitoring required.
• Limits Losses: Reduces exposure to the market.
• Locks in Profits: Especially useful with trailing stops.

Cons

• Execution at Market Price: Won’t get the exact price limit due to price gaps.
• Premature Triggers: Sells during price dips, missing the recovery.

Stop Loss Mistakes

1. Stops Too Close

• Triggers unnecessarily on small price movements.

2. Ignoring Market Conditions

• Setting stops without considering volatility or liquidity will result to poor execution.

3. Relying too much on Stop Loss

• It’s effective but not a substitute for overall risk management.

Q&A

1. How does Stop Loss work in trading?

Stop loss orders sell a security when the price hits the stop price to limit losses.

2. What is the 7% Stop Loss Rule?

A rule where you sell a stock if it drops 7% from the purchase price to avoid big losses.

3. Do you buy or sell a Stop Loss?

Stop loss orders are used to sell an asset to limit further losses.

4. What is an example of a Stop Loss?

A trader buys a stock at $50 and sets a stop loss at $45. If the price goes to $45, the order triggers and sells the stock.

Summary

Stop loss orders are a must have risk management tool for disciplined trading. Whether you’re in the stock market or financial markets, knowing how to use stop loss can protect your investments and improve your long term trading results. By using stop loss according to your trading style and market conditions, you can manage risk and achieve more in your trading.