A common fear people have about investing is that it’s gambling. They think they would lose on average. But that’s not the case and investors who lose often have a common trait – they don’t know when to leave the game. Having an exit strategy is important, and a stop-loss order can be a crucial part of that strategy. Designed to minimize losses and possibly lock in gains, stop-loss orders can be an investor’s best friend.

What is a Stop-Loss Order?

A stop-loss order is a command to sell a security at a certain price. The goal is to limit an investor’s loss on a security’s position. The investor will set a price below the purchase price. If the security falls on or below that price, the order to sell will be executed. This can help prevent the investor from an even greater loss. But like most things in investing, it isn’t always a guarantee.

There are three main types of stop-loss orders:

  • Stop-loss market order
  • Stop-limit order
  • Trailing stop-loss order

Each type of order has its own strategy. Let’s look at what they are and how they can help your investment portfolio.

A stop loss order is a command to sell a security at a certain price.

Stop-Loss Market Order

This is your standard stop-loss order. The reason the name includes “market” is because of its function. When a security reaches your stop-loss price, it becomes a market order to sell the security at or below the price. This is ideal for traders who don’t want to manually watch and exit the market. And more times than not, loss is minimal. But it isn’t guaranteed the security will sell at the exact price. This is especially true in a fast-paced market or when major news has come out. Here’s an example with two possible outcomes…

You purchase 100 shares at $50 each. You set a stop-loss order for $40. This means if the price of the shares falls to $40 or below $40, a market order will be executed to sell them.

Ideally, the share price falls and hits $40. It triggers the order, and the shares sell at $39.95. You effectively minimize your loss, and you avoided a possible devastating loss.

Worst-case scenario – Let’s say the company was exposed for fraud. Its stock tanks. When the market reopens, the stop-loss order is triggered. But the securities sell at a mere $5. With 100 shares, that’s a total loss of $4,500. This issue is called slippage.

Stop-Limit Order

A stop-limit order trades securities at the stop price or better. Since the stop-loss market order takes any price at or below the stop, a stop-limit order can avoid slippage. But it leads to a greater problem. If the market is moving aggressively and it’s moving against you, you don’t get out of the market. Stop-limit orders have two prices: the stop price and the limit price.

Let’s say you have those 100 shares you bought at $50 each. You set a stop price at $45. This means if the price drops to $45, the order will be triggered. You set a limit price of $40. This is the lowest price you’re willing to sell your shares.

Ideally, the price hits $45 and triggers the order. If the price is within that $40 to $45 range after the trigger, the shares will sell. This minimizes your loss to between $500 and $1,000.

Worst-case scenario – An aggressive market drops the share price to $35. Although the price is below the stop, it isn’t above the limit. So the order is never fulfilled. Without fulfilling the order, your loss continues to grow the further the price falls. And you hope the price recovers.

Trailing Stop-Loss Order

A trailing stop is a stop-loss order set to a certain percentage below the market price. As the security price increases, so does the stop price. But the stop price doesn’t move if the price drops. So a trailing stop loss can further limit losses and even lock in gains. But trailing stops aren’t always a guaranteed win. Let’s look at how it can play out.

For your 100 shares, you set a 25% trailing stop. Since you bought them for $50, that would make your original stop price $37.50. But the company does well, and their value goes up. Your shares go from $50 to $80. Because trailing stops move with an increase in price, your stop price is now $60. If the stock price then falls to $70, the stop price stays at $60.

Ideally, when the price hits $60, it triggers the order. Your shares sell for $60 each, and you make a profit of $1,000.

Worst-case scenario – The stock price jumps right over your stop price. The order then acts as a standard stop-loss order. The shares sell for whatever the market price is after the order is triggered. If we take the same scenario as the stop-loss market order, your shares sell for $5 apiece for a loss of $4,500.

Note that you shouldn’t set your stops too close to market prices. No stock moves up in a straight line. Having a tight stop price can lead to selling a winning stock while it’s going through normal market price swings.

For more information on how to manage risk, check your position sizing with our Position Size Calculator. And don’t forget to sign up for our free e-letter below! More informed decisions lead to better investing. And a stop-loss order is an effective and easy way to help minimize loss.