Why can you benefit from stop-loss orders

Stop losses are a crucial part of managing a trader’s risk, and every good trading plan should cover their use. This article delves into what stop-loss orders are and how and why to use them.

What is a stop loss?

A stop-loss is a pre-established level that a trader can set to exit a trade. These orders can be configured to execute automatically on most trading platforms. They are the converse of take-profit orders, which are also used to exit positions. The difference between stop-loss and take-profit orders is that the former is usually used to limit a loss while the latter are used to realize a gain once the value of an asset has risen a certain amount above the purchase price.

It is important to note that the price at which an asset sells once the stop order executes is not necessarily the price at which the order is set. Rather it is the best available market price at that moment. This difference (called “slippage”) is usually negligible for highly liquid securities, but it can be significant for more thinly traded assets.

How to set stop-loss levels

Good traders’ stop-loss orders reflect their risk tolerance and are set based on that tolerance and the size of their position. Say a trader has the rule to risk only 2% of his capital in any given trade, and he has $10,000 of total capital. This means the maximum loss he is willing to take is $200. This trader then buys 20 shares of stock at $100 per share. Based on his risk tolerance, he would set his stop loss at a share price of $90 because if the stock falls below this level, the loss will exceed 2% of his total capital.

Setting a stop-loss is a very personal decision rooted in a trader’s motivations and objectives but placing this order beforehand as part of a larger plan is a way to gain objectivity in trading and avoid irrational or emotional decisions that can lead to more significant losses. Some traders set stop losses based on technical indicators, like Fibonacci retracements. A general rule of thumb is that the more active a trader is (i.e. the tighter their trade turnaround times are), the tighter their stop loss levels should be. A stop-loss should leave enough room for a stock’s normal fluctuations within a given period without allowing the bottom to fall out of a position.

Using a stop-loss to guarantee profits

While the most common use of a stop-loss is to keep you from bleeding cash, it can also be used to make sure you get a certain profit level from your investment. Say you’ve bought a stock, and its price has gone up significantly since that time. Based on your strategy, you know you don’t want to hold the stock long term, and you would like to cash in on at least some of those gains, but you also have reason to believe the stock could continue to climb. You could set a stop-loss at a level below the current market price but above what you paid for the security. This allows you to continue to bet on stock ensuring you’ll benefit from at least some of its gains.

When a stop-loss order could be detrimental or not helpful

If you have a passive, buy-and-hold strategy, stop-loss orders will not benefit you much. The philosophy behind this type of investing, where money is usually put in highly diversified funds, is that the market will increase in value over time. Hence, it is better to stick with positions through thick and thin rather than try to predict movements and time the market.

Another possible downside to a stop loss is that, since it is automatic, high volatility or other blips could trigger it unnecessarily, causing you to lose a position you weren’t ready to exit and saddling you with a commission for executing the trade.