A stop-loss order is an order placed with a broker to sell a security when it reaches a certain price. Stop-loss orders are designed to limit an investor’s loss on a position in a security. Although most investors associate a stop-loss order with a long position, it can also protect a short position, in which case the security gets bought if it trades above a defined price.
BREAKING DOWN ‘Stop-Loss Order’
A stop-loss order takes the emotion out of trading decisions and can be useful if a trader is on vacation or cannot watch his or her position. However, execution is not guaranteed, particularly in situations where trading in the stock halts or gaps down (or up) in price. A stop-loss order may also be referred to as a “stop order” or “stop-market order.”
If an investor uses a stop-loss order for a long position, a market order to sell is triggered when the stock trades below a certain price; the order then gets filled at the next available price. This type of order works efficiently in an orderly market; however, if the market is falling quickly, investors may get a fill well below their stop-loss order price.
Stop-Loss Order Example
If you own shares of ABC Inc., which is currently trading at $50, and want to hedge against a significant decline, you could enter a stop-loss order to sell your ABC holdings at $48. This type of stop-loss order is also called a sell-stop order. If ABC trades below $48, your stop-loss order is triggered and converts into a market order to sell ABC at the next available price. If the next price if $47.90, your ABC shares sell at $47.90.
Stop-Loss Order Gapping
Suppose ABC closes at $48.50 and then reports weak quarterly earnings after the market close. If the stock gaps lower and opens at $44.90 the next day, your stop-loss order would be automatically triggered and your shares sell at the next available price, say $45. In this case, your stop-loss order did not execute as expected, and as a result your loss on ABC is 10% rather than the 4% you had expected when you placed the stop-loss order.
Price gapping is a major drawback of stop-loss orders and a reason why many experienced investors use stop-limit orders instead of stop-market orders. Stop-limit orders seek to sell the stock at a specified limit price, rather than the market price, once a specified price level gets breached. Although stop-limit orders do not offer investors a perfect solution, they do reduce the risk of a long position selling at a price that is significantly below a stop-market order.
Price gapping is reduced in markets that trade 24 hours per day, such as forex and cryptocurrency. Investors still need to be aware that prices can gap below or above stop-loss orders due to adverse macro news or times of low liquidity. For example, the price of bitcoin could gap lower if regulators announce a new tax for goods and services that are purchased using the cryptocurrency.