What it means
A stop-loss order is an instruction to the broker to exit a position if the price touches a chosen level. When that level is hit, the order usually turns into a market order and is filled at the next available price.
The investor is then said to have been stopped out. The attraction is discipline.
Setting the exit before entering the trade removes the temptation to hope for a recovery, and it caps the amount that can be lost on a single idea. Professionals typically risk only a small fraction of their capital on any one trade, often 1% or 2%, and the stop is what enforces that.
There are practical limits. In a fast market or after overnight news, the price can jump past the stop, so the trade is filled at a worse level than planned, which is called slippage.
A stop set too close to the entry price can also be triggered by ordinary day-to-day movement, after which the price recovers. A variation is the trailing stop, which moves up as the price rises, protecting profit instead of only limiting loss.
Another is the guaranteed stop, offered by some brokers for a fee, which fills at the exact level even in a gap. The costs and conditions differ, so read the terms.
Businesses meet the idea in treasury and commodity hedging policies too. A policy may require a hedge to be closed if the loss reaches a set limit, and a trader who breaches that limit can be stopped out of the position by the risk team.
The principle is the same, a loss limit agreed before the trade.
In practice
Real-world examples.
Example
An investor buys shares in a retailer at $25 and sets a stop at $22. After disappointing sales figures, the price falls through $22 and the broker sells the position. The investor accepts a 12% loss and avoids a further fall to $15.
Example
A currency trader sets a stop 40 points from her entry. A routine data release moves the market 45 points in seconds, and she is stopped out before the price quickly recovers. She learns that a stop that is too tight can be triggered by noise.
Example
A company's treasury policy requires any speculative commodity position to be closed if it loses $100,000. The risk team closes a position at that point when oil prices move sharply. The board is told the same day, and the policy limit prevented a larger loss.
Formula
Calculation
Loss when stopped out = (entry price - exit price) x number of shares, plus costs
Slippage = actual exit price compared with the stop price
A trader buys 500 shares at $40 and places a stop at $36, so the planned loss is (40 - 36) x 500 = $2,000. Overnight bad news causes the shares to open at $35.50, and the stop fills there. Actual loss = (40 - 35.50) x 500 = 4.50 x 500 = $2,250. Slippage cost = 2,250 - 2,000 = $250. The loss is 2,250 / 20,000 = 11.25% of the $20,000 invested.Case study
Seen in the real world.
Harlow Growth Fund is an illustrative, fictional fund with $5,000,000 under management. Its rules say that no single position may lose more than 1% of the fund, which is $50,000.
The fund buys 10,000 shares at $30 and sets a stop at $25, giving a planned loss of 5 x 10,000 = $50,000. A takeover rumour collapses overnight, the shares open at $23.80, and the stop fills there for an actual loss of 6.20 x 10,000 = $62,000.
The fund keeps its risk to 1.24% instead of 1% of assets and survives easily, but the risk committee reduces position sizes for shares that can gap. The illustrative lesson is that a stop controls losses but does not guarantee the exit price, so sizing should allow for gaps.
Watch out
Common mistakes.
- Assuming a stop guarantees the exit price, when a gap can fill the order well beyond the stop level.
- Setting the stop too close to the entry price, which often leads to being stopped out by normal price movement and then watching the price recover.
- Moving the stop further away after the price approaches it, which defeats the purpose of having a plan.
Questions
People also ask.
What does it mean to be stopped out?
It means your stop-loss order was triggered because the price hit your chosen level, and the position was closed automatically.
Is a stop-loss the same as a stop-limit order?
No, a stop-loss becomes a market order when triggered and fills at the next price, whereas a stop-limit order fills only at the limit price or better and may not fill at all.
How should I choose where to place a stop?
Many traders base it on the instrument's normal volatility or on a level where the original idea would be proved wrong, and they size the position so that the loss is acceptable.
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