As the name implies, stop-loss orders are a way to help you manage the amount of loss you can suffer on a single holding. Also known as a stop order or stop-market order, a stop-loss order sets a level at which your broker is instructed to sell all or part of a particular position once the stop-loss point is reached.
With a stop-loss, you can specify a share price below which you do not want to hold a stock. Once the bid price hits that level, the position would be sold automatically at the market price. You also can employ what’s known as a trailing stop-loss to adjust the stop upward if a security’s price rises. The stop might be calculated as a percentage or a dollar amount relative to the bid price (for example, a loss of 10% or a $2 per share drop). If the stock’s price moves higher, your stop level also rises. That can help protect a portion of your paper profits while potentially allowing you to participate in any further upward appreciation. If the price falls, the holding simply moves closer to the level at which it will be sold.
In addition to helping you minimize losses you can’t handle, stop-loss orders are one way to remove emotion from your investment decision-making. They also can be especially useful if you’re anxious about volatile markets at a time when you know you’ll be traveling in remote areas and unable to monitor your accounts easily.
However, under certain circumstances, stop-loss orders can be a mixed blessing. Just because you’ve specified a certain stop-loss level doesn’t mean your trade will be executed at that exact price; once your specified level is triggered, the trade will be executed at a market price. If markets are extremely volatile or if a security is thinly traded, you might lose more than the amount you expected.
For example, during the 2010 “flash crash,” when prices plummeted and markets were temporarily illiquid, some stock positions were sold at prices well below the stop loss. Some of those trades were subsequently voided, but it’s still a good idea not to take the protection of stop-loss orders for granted, and to know that there can be a gap between expectations and execution.