How To Get More Out Of Stop-Loss Investing

January 18, 2022

Investing is inherently a risky business. There would be no reward at the end of the investing journey if there was no risk associated with it on the front end. This is why it is so important to know how to control those risks and how to shape your investment journey in such a way that you don’t overextend yourself on any one trade. One of the most effective ways to do this is to use something known as a stop-loss to help control your overall risks.

What Is A Stop-Loss Order?

Defining a stop-loss order can help traders better understand what they are doing when they make this selection. The Securities and Exchange Commission (SEC) has put out a document with this helpful definition of what a stop-loss order is:

A stop order, also referred to as a stop-loss order, is an order to buy or sell a stock once the price of the stock reaches a specified price, known as the stop price. When the stop price is reached, a stop order becomes a market order. A buy stop order is entered at a stop price above the current market price. Investors generally use a buy stop order in an attempt to limit a loss or to protect a profit on a stock that they have sold short. A sell stop order is entered at a stop price below the current market price. Investors generally use a sell stop order in an attempt to limit a loss or to protect a profit on a stock that they own.

Now, let’s see if we can break this down a little more. Essentially, when a trader decides to purchase a stock, they know that they are taking some risk that the price of that stock will go down. They have to put their money upfront when they place the trade, and they have to understand that this could backfire on them if the trade goes against you, as happens sometimes in the market. So, what can a trader do to attempt to limit the risk that he or she takes when buying a stock? One answer is to place a stop-loss order on the trade in order to control the risk from the moment it is purchased.

Example Of How A Stop-Loss Works

Giving an example of how a stop-loss order works may be the best way to solidify the concept in the mind of someone who has never dealt with this before. Trader A decides that he or she wants to buy the stock of Company B because the trader believes that the value of the shares will rise. Trader A also wants to place a stop-loss order in order to control his or her risks. The sequence of events works like this:

  1. Trader A sees the price of Company B is trading at $20 per share and believes that this is a good price.
  2. Trader A places a buy order for 5 shares of Company B for $20 per share for a total of $100 invested.
  3. Trader A simultaneously places a stop-loss order for all 5 shares at a price of $15 per share.
  4. Trader A has therefore instructed the programs that control their trades to place a sell order of all 5 shares at a price of $15 per share if the price dips to that level.
  5. If the price of Company B goes to $15 (or lower), the trade will automatically execute.
  6. Trader A will have sold 5 shares at $15 for a total of $75, a $25 loss.

You might look at this and wonder why the trader would want to lock themselves into a potential loss on their investment. The reason for this is because they recognize that the stock could in fact trade even lower. What if it turns out that Company B is actually a fraudulent enterprise and the stock drops all the way to $0 per share once they are exposed? In that scenario, the trader would be out their full $100 initial investment.

Why Should You Place A Stop-Loss Order At All?

The purpose of placing a stop-loss order is simple: You can’t monitor the markets 24/7!

You don’t want to see the value of your portfolio drop below a certain level, so you place stop-loss orders to ensure that your losses are contained to a certain point, and you can ignore the markets and allow your investment to do whatever it is going to do.

Most market experts agree, a dollar saved on investments is just as good as a dollar earned on one. Therefore, you should try to focus on your risk-controlling measures just as much as you focus on how you will grow your investment account. Both are important, and both deserve your attention.

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