Stop-Loss Orders…What They Are And Why They’re Important

There is one seemingly simple trick to implement today to make yourself a better trader. I say seemingly simple because in theory there’s no reason why every trader wouldn’t use it. But in reality, it’s not implemented nearly as often as it should be and sometimes overlooked. What I’m referring to is setting stop loss orders for positions you’ve entered thereby removing the possibility of a stock continuing to trade farther against you past your loss threshold. This strategy helps traders mitigate risk and remove emotion from a trade.

What is a stop loss order? A sell-stop order protects a trader’s long positions by triggering a market sell order if the price falls below a certain level. Placing a sell-stop loss can effectively ensure that you will liquidate a position that is going against you. Let’s give a basic example of what a sell-stop loss order is below.

Sell-Stop Loss Example: Say you purchase stock XYZ at $50 and decide that you no longer want the position if the price falls to $45. There are many strategies that can be used when determining the sell-stop loss price point you choose…it can be based on amount of money you’re willing to risk, technical analysis, etc. When XYZ stock trades at $48, the order triggers and becomes a market order. You’ll get the current price available for the security under the prevailing market conditions. This means that you may get filled at $48 or if the stock is moving quickly or less liquid, it may also get filled at a lower price point. Remember, the $48 trade price is just the trigger for a market order that becomes executable at the next available price in the market.

Sell-stop loss vs sell-stop limit difference: There is a major notable difference between a sell-stop loss and a sell-stop limit and it’s important to understand the difference. The sell-stop loss becomes a market order and will be executed as shown above. A sell-stop limit is also triggered at the price point however the sell order is entered at that stock price. In the example above, once the stock trades $48, a limit sell order for the shares will be entered at $48. If the stock is moving quickly there is a chance that the order does not get filled and can continue lower. Your order would remain a sell order with a limit price of $48.

Sell-stop orders are a great way to take emotion out of a trade and protect yourself from allowing a trade to get too far against you. Many traders will set mental sell stops for where they propose they want to get out. The question is will they stick to that mental stop and liquidate or break their own rules and hope it turns around. Previously one of the nation’s top S&P futures traders, Lewis Borsellino, said “I’ve seen too many traders staring panic-stricken at the computer screen and begging the market to move their way. Why? Because they have lost their discipline and allowed what was a small loss to turn into a much bigger one. They keep hanging on, hoping, wishing and praying for things to turn around. The reality is on the screen. When the market hits your stop-loss level (the predetermined price at which you will cap your risk), get out.”