Stop-Loss Order

What is a Stop-Loss Oder?

The risk management tool that traders use to automatically sell a security when it reaches a specific price level is known as a “stop-loss” order. By placing such an order with the broker (these are different market enablers such as trading platforms) traders are aiming to limit their potential losses or in some cases to lock in a certain level of profit and exit a position at a desired by them price. This approach is widely used in both stock and foreign currency (or forex) trading and can prove effective during periods of market turbulence or when investors don’t have the resource to actively monitor their holdings. However, the actual execution price may not be exactly the same as the pre-set one as a result of slippage or market gaps (occurring when there are breaks in price with no trading taking place between them).

How Stop-Loss Orders Work?

Stop losses are relatively straightforward and can be implement in just a few steps:

1. Determine and set a stop price – this would require traders to perform fundamental analysis (i.e. examine the financial statements of the company and calculate various ratios) and/or analyze different share price trends through technical analysis. Once they are ready to make an informed decision, a stop price is set.
2. The order gets triggered – in the event the security reaches the stop price, the stop-loss order is activated, and it turns into a market order.
3. Execution – once triggered, the stock is automatically sold at the next best available price which can be slightly lower or in rare cases higher than the stop price due to higher market volatility (known as slippage).

There is also another variation in which traders set up trailing (also referred to as rolling) stop losses. This means that if the price of a security moves up the stop-loss will also move higher.

Stop-Loss Example

A trader considers what would be an appropriate level to set a stop-loss order. The stock that is to be potentially traded has been relatively volatile over the past couple of weeks with moves of up to 8% in each direction. Therefore, the trader decides that setting up a stop-loss order at 10% below the current price would be a good target as it gives the stock price a bit more flexibility to fluctuate relative to its previous highs and lows.

The current price of the security is $100 per share. Using a 10% rolling stop, the broker will execute a sell order if the price drops 10% below the purchase price (i.e. $90), but should the price go up, that 10% will apply to the current price. For example, if the stock goes up to $105, then the 10% stop-loss order will become active if the price drops to $94.5.

The below table describes the different order types.

Stop-Loss Orders Aren’t Always Appropriate

Although they are primarily intended to manage risk, in some cases stop losses may not work in traders’ best interest. During periods of elevated market volatility, they can lead to unnecessary selling, meaning that a price level that has been set up to work in normal market conditions can easily be reached when the market overreacts to specific news or events. That short-term fluctuation may not be indicative of deteriorating fundamentals, and the price of the security could quickly recover but the trader would not be invested anymore.

Stop losses are usually disabled for afterhours trading as prices can be quite volatile and an order may be executed at unfavorable price. As prices are typically calculated off the bid price (i.e. what other market participants are willing to pay), taking into account the security’s liquidity level is quite important. This is because in the event of poor liquidity the bid-ask spread (the difference between what the market is willing to pay and the price that the seller asks for) would widen and trades will be executed at an unfavorable price. This can be often observed in less liquid areas of the market such as emerging and frontier markets, and/or companies with small market capitalization.

Stop-Loss Order vs. Stop-Limit Order

Traders use both the stop-loss and stop-limit orders as a risk control mechanism to aid them prevent losses. The main difference between the two is that while a stop-loss order turns into a market order and is executed immediately after a specific price is reached (this could be at a lower than the specified price), stop limit turns into a limit order at that pre-set price, meaning that the order will be executed only at the specified price or better. Therefore, stop limits require traders to enter two prices – a stop price and a limit price (which could be equal or below the stop price). Once a security reaches the stop price, a trade can only be executed if the next available price is at the limit or above. If the stop and the limit are set up too close, this creates a risk that in a rapidly declining market execution may not be possible, which can respectively lead to further losses.

Stop-Loss Order Example

Below is some stock price information for Tesla Inc. in US Dollars.

Data source: Investing.com

An investor purchased the stock on the 11^th of November at $352 per share (prices fluctuate throughout the trading day with the highest and lowest shown on the right side of the table).

He put a stop-loss order at 10% below the price the shares have been purchased. This means that the stop-loss will turn into market order when the price reaches $316.8 (352*0.9=316.8).

Over the next two trading days, the lowest the company’s share price dropped was $322.5.

However, on the 14^th of November Tesla’s price dropped down to the stop-loss level and triggered a market order. The stock was sold at the best available price at that moment, which was $316.1.

The below chart visualizes the whole process.

Benefits of Stop-Loss Orders

There are several benefits that stop losses offer traders, the most important of which are:

• Stop-loss orders are relatively simple to understand and easy to set up. They save investors time by automating the sale process and removing the need for constant monitoring.
• They eliminate emotions from the decision-making process and strengthen investors’ sell discipline, helping them to limit potential losses.
• Stop-losses can also be used to lock in profits when a security reaches a certain level above the purchase price.
• Along with the above-mentioned risk management features, they also protect investors from sudden and unexpected market downturns.

Advantage Over a Stop-Limit Order

The biggest advantage that stop-loss orders have over stop limits is certainty. The stock market is quite dynamic and changes in the direction of travel can be sudden and unexpected. Therefore, for traders that require a guaranteed execution immediately after a price level is breached and are comfortable to accept even a more unfavorable price, a stop-loss will be more appropriate. It also provides stronger protection against bigger losses since a stop-loss does not rely on a specific price to complete a trade. This is often the case in less-liquid markets, for example during a sell off when market participants are looking to sell. In such a scenario, a stop-loss will turn into market order at the next available price while stop-limits may remain unfilled.

Conclusion

To sum up, stop-loss orders are useful risk management tools that helps investors prevent losses. It is a simple operation and requires traders to set up a certain price level that would trigger a sale (it can also be used to lock in profits if the price of a security appreciates). In some cases, the price at which the trade is executed would slightly differ to that of the stop-loss since the order gets filled at the next available price.

Additional Resources

Passive (Index) Investing

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Portfolio Analysis

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