There are many ways to trade stocks or ETFs. Most of the time, it takes a simple market or limit order to get the job done. But not always. Sometimes you need to add a condition when placing an order. A stop order or stop-loss order is the tool to use.
Conditional orders have a place in every investment strategy. When used properly, a stop order can help automate trades, enforce investment disciple and most importantly act as insurance.
Stop Order Defined
A stop order is a market order with a twist. It’s defined as:
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. – SEC
Once that stop price is reached, the stop-loss order becomes a market order and the stock is sold at the next available price.
A sell stop order has a stop price below the current market price. It’s an order to sell at the best available price if the price drops below the stop price. It’s most often used to protect yourself from extra losses or to protect a profit.
A buy stop order has a stop price above the current market price. It’s an order to buy at the best available price if the price rises above the stop price. It’s best used to limit losses or protect a profit on a short sale.
Confused yet? The common goal here is all about protection.
It’s About Protection
Say you bought an ETF that is up 100% over the past three years. It’s had a great run. You don’t want to sell, but you don’t want to lose that paper profit entirely should something happen. You can set a stop order to protect those profits. If the share price keeps going up, nothing happens and your profits grow. But if the share price falls you are protected. And you won’t have to sit and watch that ETF every second of every day either.
On the other hand, the same can be done with a stock you just bought. What if you only wanted to risk losing 10%. You can set a stop price at 10% below what you paid. This helps limit your losses if the stock price drops that low.
The idea here is a basic form of insurance. If you own a stock at $20 a share but only want to risk losing about 10%, you can place a stop-loss order at $18. If the price ever drops to $18, the stop price is triggered and the shares will be sold at the next best available price.
Things to Consider
We covered protection as the biggest advantage to using stop-loss orders but there are others. It’s also not all rainbows and roses either. There are a few downsides too.
Pros
- There is no cost to placing a stop order. You won’t be charged a commission until the stop price is triggered and the shares are sold.
- Knowing when to sell is just as important as knowing when to buy. Deciding on an appropriate sell price early gives you a plan and stop-loss orders force you to follow through with it.
- It offers the ability to automate a trade so you don’t have to be constantly connected to your online broker.
Cons
- Stocks and ETFs with high price fluctuations can easily trigger a stop price and sell prematurely. Choosing the right stop price is key.
- Because a stop-loss order becomes a market order, the stop price is not the guaranteed selling price. In a volatile market, the price could easily fall further before a sale occurs.
- There is a chance, though small, that a stock never hits its stop price as the price is falling. This can happen between the market close and open. If the stock price closes at $19 one day, with a stop price at $18, but opens the next day at $17, the stock can continue to fall without anything happening.
If you’re not sure if a stop order is the best trade to use, just stick with a market or limit order. Those will be used most often anyways. Every once in a while, a situation pops up and the extra insurance, automation and forced discipline of a stop-loss order just makes more sense.
