Stop-loss orders are an important tool in any trader’s toolbox. When used correctly, stop-losses can help you protect yourself from losses and limit downside risk. However, if you’re new to investing, there’s a good chance that you don’t know what the heck a stop-loss order does. Before you get started trading stocks, it’s important that you know how to use this powerful tool.
What Are Stop-Loss Orders?
Stop-loss orders offer a way to conditionally buy or sell stocks or other securities when they reach a certain price. Investors commonly use stop-loss orders to protect themselves from further losses. When a stock reaches the specified price, the order converts into a market order and executes as the next available price.
The most commonly used stop-loss order. A stop sell tells your broker to execute a market sale when a security reaches a specific price. These work great for protecting your principle from further losses and serve as a predetermined worst-case exit point for a trade.
Stop buys tell your broker to buy a security if it reaches a certain price. You can use stop buys to enter into a trade when a stock hits a price that’s higher than its current position. This can be useful for covering short positions or initiating a trade automatically after a stock breaks above a key technical support level.
How To Use Stops
Stop-loss orders help traders automate their trading strategies and limit their downside risk. Placing a stop-loss can usually help cap losses. For example, if you want to invest in a $10 stock and limit your losses to 30%, you should enter a stop-loss order at $7 after you purchase the stock. That way, the stock will sell as soon as the price hits $7. If it goes any lower, you’re already out of your position so you protect yourself from further losses.
Technical Analysis & Stop-Loss
Stop-loss orders are great tools for technical traders. Setting up stops at key support points can help protect you from big dips. If share prices break below a key support level, they are likely to continue to fall further. Therefore, placing a stop right below key support enables you to exit your position before prices slide even further. However, they also allow you to stay in the trade for as long as possible without having to sell your shares prematurely.
Example: S&P 500
If you bought the S&P 500 at around 2,970, it might be wise to look at the chart to identify key technical levels to help you place your stops. Placing stops below key technical support is a great way to help limit your downside risk. With some quick technical analysis, we can see that the S&P 500 has strong support at 2,750. This provides a great place to place stops. If prices reach these levels, it seems that they would be likely to continue towards greater losses.
Be mindful that stocks are volatile assets that often fluctuate significantly in price during times of heightened uncertainty. A stop-loss order will execute as soon as prices reach the set stop level, so you need to leave enough room for regular volatility to run its course. Make sure that your stop is far enough below key support levels that it won’t be executed because of normal fluctuations in prices. Otherwise, you could find yourself sitting on losses while share prices rebound and you’re sitting out.
Limitations of Stop-Loss Orders
Traders should exercise caution when they use stop-loss orders. These aren’t the one-size-fits-all solutions that some make them out to be. In fact, if you’re not careful, stops can actually puy you on the wrong side of a trade.
Stops offer traders a way to protect their downside in the event of unexpected downward moves, but they shouldn’t rely on them entirely. Stocks can make big jumps down in prices. Don’t let stop losses give you a false sense of security. Pay attention to your portfolio and only rely on stop orders to protect you in the event of an emergency.
Stops come in more than one variety. In addition to the types of orders discussed here, you can also enter stop-limit orders. Stop-limits are similar to traditional stop orders, but they are different in one key regard: they convert into limit orders, instead of market orders, when they reach the preset price. More on stop-limit orders here.