Stop Loss

Financial Dictionary -> Investing -> Stop Loss

Stop loss is an instrument establishing the price at which an investor is going to sell stock. Stop losses are typically employed to protect long positions, limiting the amount of loss if a trade goes against the investor. There are two kinds of stop loss: regular and backup exit. With the first option, the investor will keep the stop loss close to the current market price. However, with backup exit, also known as emergency or crash stop loss, the stop loss will be set lower than the normal exit. In this case, it is not an exit but an emergency backup.

To begin with, let us fairly suppose that a stop loss order has to do with one's investment portfolio, as it is designed to prevent or limit the investor's losses to certain extent. For example, if you activate a stop loss order at ten percent below the price you bought your stocks, your possible loss will be limited to ten percent. In other words, you buy shares of a certain company at a price of $10 per share and set up a stop loss order at $8. Thus, your shares will be automatically sold at the prevailing market price, if their value drops below the security position of eight US dollars. In other words, the stop loss order is transformed into a market order, with your broker selling the stock at the best available market price.

Here are some of the advantages and disadvantages of setting up a stop loss order. First, a stop loss order will give you the peace of mind to know that even if your investment boat starts sinking, it will not hit the rock bottom, so you don't have to bother keeping an eye on the daily performance of your stocks on the global markets. A common mistake that most budding investors do is to set up a too tight safety bracket. As you may know, fluctuations in the prices of stocks usually vary within certain limits, and you should choose a security position that will give your stocks enough room for fluctuation. For instance, if a stock fluctuates 2-5 points, it will be unwise to set your stop loss order close to this range. Otherwise, you may lose heaps of money on bulky commissions that are charged each time a stop loss order is triggered.

Experienced investors tend to use wider stop-loss brackets, especially if they pursue a long-term investment strategy, while narrow stop loss margins are for active traders who are after short-term profit. So, depending on the personal investment style, traders choose different levels to place stops. The long-term investor may opt for fifteen percent or more while the active trader may use a figure in the range of five percent.

It should also be noted that stocks that are traded over the counter as well as penny stock do not allow a stop-loss margin. On the other hand, if you set a stop loss order at some percents below the current market price of your stocks, you will use what is referred to as a 'trailing stop' to let your profit flow. At the same time, you will allow for some future benefits and capital gain.

In a nutshell, if used responsibly, a stop loss order may help you stir your boat through the financial ocean smoothly and comfortably, regardless of any unfavourable market conditions that might occur.