The Ultimate Guide to Stop-Loss Investing

January 11, 2022

While it is important to actively manage your investments, there are times when speed is the most important factor in making the best decision. Times when you need the consideration taken out of your hands so that you can make a judgment call quickly. And given the rapid turnover of stocks, it’s especially important to make decisions based on the right information—and to do it quickly.

That’s where stop-loss investing can make a world of difference for investors.

Here’s a breakdown of everything you need to know about stop-loss investing and how to make it work for you.

What is a Stop-Loss Order?

Stop-loss investing isn’t a full-fledged investment style per se, but rather a technique for making rapid-fire investment decisions that rely on a stop-loss order.

A stop-loss order is an order to buy or sell a stock once it reaches a certain price level. This is a simple but essential mechanism designed to minimize an investor’s loss on a security position. Many investors associate stop-loss orders with long-term investments, but it’s just as useful for protecting a short position.

How It Works

While a stop-loss order follows a simple mechanism, it’s often misunderstood.

A stop-loss order is an order to buy or sell a stock once it reaches a specific price, known as the stop price. Once the stop price is reached, the stop-loss order becomes a market order, an order to buy or sell a stock at the current price. As long as there are willing buyers and sellers, you’re guaranteed that your market order will be executed.

There are two types of stop-loss orders: buy stop orders and sell stop orders. Buy stop orders are entered at a stop price above the current one, while sell stop orders are entered at a stop price below the current one. In both cases, the goal is to limit loss, either on a stock you sold short or on a stock you already own.

Keep in mind that the stop price is not the guaranteed execution price for a stop order. The stop price is merely the trigger for the stop-loss order to become a market order, which means there’s some delay between the order and the execution.

Stop Loss vs. Stop Limit

A stop-loss order is not to be confused with a stop-limit order, though they follow a similar premise. Both are designed as tools to limit potential losses, though they do so in different ways.

A stop-limit order is broader than a stop-loss order. A stop-loss order specifies the exact price you’re willing to buy or sell. A stop-limit order also contains a stop price as a trigger, but it includes the highest or lowest price you’re willing to accept for the stock.

Basically, it’s a hybrid of a stop-loss order and a limit order. Rather than becoming a market order upon reaching the stop price, a stop-limit order becomes a limit order. A buy limit order can only be executed at or below the limit price, while a sell limit order can only be executed at or above the limit price.

Because of this, stop-limit orders contain two prices: the stop price and the limit price. The stop price works the same as a stop-loss order. The limit price is an order to buy or sell a specific number of stocks once the price reaches a certain point.

Both are incredibly useful tools for investors. In fact, advisors often recommend using stop-limit orders in tandem with stop-loss orders to reduce the risk of a significant gap between the execution price and the stop price.

Advantages of Stop Loss Investing

One of the biggest advantages of stop-loss investing is that it removes a lot of emotional influences that might otherwise color investment decisions. While investors like to think they’re rational, people often fall in love with a stock or a company and hold onto it despite red flags. A stop-loss order is like a metal detector—it doesn’t care about the circumstances, it just executes when it senses the right conditions.

Another key advantage is that it doesn’t cost anything to implement. Think of it like a free insurance policy—your commission is only charged once the stock is sold.

Disadvantages of Stop Loss Investing

That said, there are a few disadvantages of stop-loss orders that you should be aware of.

First, it’s important to remember that the stop-loss order executes automatically. That means that a stop-loss order may be triggered by intraday price movements, resulting in an execution price much weaker than the stock’s closing price for the day.

Second, it’s important to remember that stop-loss orders don’t mitigate all risk. For example, if a company reports disappointing earnings after the market closes for the day, the share price at the start of the next market day could be well below your stop price.

Unfortunately, there’s not much you can do to prevent either disadvantage. You just have to be aware of them and prepared to accept the risk.

Ready to Get Smart With Your Money?

As an investor, it pays to be smart with your money. Stop-loss investing is one way that you can take emotions out of the equation and make concrete decisions to protect your investments. However, it isn’t a replacement for a smart investing strategy. You still need to do your homework to find good investments and make smart decisions.

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