What it means
When you buy a share, you expect the price to rise, but you cannot be sure. A protective stop is the plan for when you are wrong: you choose a price at which you will accept the loss and leave.
If the price touches that level, the order is triggered and your position is closed. The most common form is the stop-loss order.
For a long position, you place a sell stop below the current price, and for a short position, you place a buy stop above it. Once the stop price is reached, the order usually becomes a market order, which means it is executed at the next available price.
That last point is important. The price you receive can be worse than your stop price, a difference called slippage, especially in fast markets or when prices gap overnight.
A stop-limit order sets a minimum price to avoid this, but it may not be executed at all if the market moves past the limit. Where to place the stop is a key decision.
If the stop is too close, normal daily swings will trigger it and force you out of a good position, and if it is too far, the loss when it triggers is larger than intended. Many traders base the distance on how much the price usually moves, or on a recent low that would show the original idea was wrong.
A protective stop is also a tool for sizing the trade. By deciding the amount you are prepared to lose before you enter, and knowing the distance to the stop, you can work out how many shares to buy so that a stop-out costs only a small, planned part of your capital.
In practice
Real-world examples.
Example
An investor buys 500 shares at $20 and places a protective stop at $18. If the price falls to that level, the shares are sold and the loss is about $1,000 plus any slippage.
Example
A trader sells short 100 shares at $80 and places a buy stop at $86. When an unexpected announcement pushes the price up, the stop triggers and limits the loss to roughly $600.
Example
A company treasurer who holds a block of shares received in a transaction places a protective stop on part of the position, so that a sudden fall in the market will not erase a gain she wants to protect.
Formula
Calculation
The risk per share is the distance from entry to the stop, and the position size follows from the amount you are willing to lose:
Risk per share = Entry price - Stop price
Position size = Amount at risk / Risk per share
Suppose a trader has a $100,000 account and is willing to risk 1% on a trade, which is $1,000. She buys a share at $50 and places a protective stop at $45.
Risk per share = $50 - $45 = $5.
Position size = $1,000 / $5 = 200 shares.
The position costs 200 x $50 = $10,000. If the stop is triggered at $45, the loss is 200 x $5 = $1,000, which is 1% of the account. If the price gaps down to $43 before the stop can fill, the loss would be 200 x $7 = $1,400.Case study
Seen in the real world.
Falcon Ridge Trading is an illustrative, fictional trading club whose members often held losing positions for too long. One member, Daniel, bought shares at $40 expecting a rise, and watched them fall to $28 while hoping for a rebound.
The club agreed a rule that every trade must have a protective stop set at the time of entry, and no stop can be moved further away. In the next quarter, Daniel's stops limited each loss to about $300, and although several trades were stopped out, two winners more than covered the total.
On one occasion a stop was filled at a price lower than the trigger because the market opened with a gap after bad news, and the club discussed this limit of stop orders. The illustrative lesson is that a protective stop gives discipline and defined risk, though it cannot remove the chance of slippage.
Watch out
Common mistakes.
- Placing the stop so close to the entry price that ordinary price movement triggers it and ends a sound trade.
- Moving the stop further away after the price falls, which turns a planned small loss into a large one.
- Assuming the stop guarantees the exit price, when gaps and fast markets can cause the order to be filled at a worse price.
Questions
People also ask.
What is the difference between a protective stop and a stop-limit order?
A stop becomes a market order when triggered and is likely to fill, while a stop-limit sets a minimum price and may not fill if the market moves past it.
Can I use a protective stop for a short position?
Yes, a buy stop is placed above the entry price, and it triggers a purchase to close the position if the price rises to that level.
Should I always use a protective stop?
Many traders do for short-term trades, but long-term investors may prefer to manage risk through diversification and position size, since stops can sell good investments during temporary dips.
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