The definition of stop loss order may quell some of your investing fears.
Common investing fears, according to the North American Securities Administrators Association (NASAA), include, “I’m afraid of losing all my money,” especially among millennials.
Definition of Stop-Loss Order: When Do You Need It?
Take our pal Claudia Clueless. Claudia had a record year running her store, Clueless Notions. Those flamingo buttons sold out in a jiffy – who knew?!
Claudia is going to give herself a well-deserved bonus this year.
She is thinking about investing it, but has fears about losing money in the stock market.
First of all, your fears are real and valid, but if you get some perspective, Claudia, we think you might feel better about letting your money grow.
As NASAA explains, “Look at the data on market performance over the long term (10, 20, and 30 years). Understand that while there are fluctuations, in general, the market has trended up over the long term.”
Still, Claudia, we don’t blame you. Investing can seem like a big boys’ game. Enter the definition of stop loss order.
Definition of Stop-Loss Order
As Charles Schwab gives the definition of stop-loss order, it is “an order to buy or sell a stock at the market price once the stock has traded at or through a specified price (the “stop price”). If the stock reaches the stop price, the order becomes a live market order and is typically filled at the next available market price. If the stock fails to reach the stop price, the order isn’t executed.”
So basically this means you can set it and forget it when it comes to minimizing your losses.
Say you buy some Apple stock at $228.00.
You used your bonus money to buy it. With your $2280, you bought ten shares.
Now, you really don’t want to lose your bonus money.
Enter the stop-loss order.
OK, SO WHAT IS IT?! Definition of Stop-Loss Order
A stop-loss order is an instruction you give to your broker to automatically sell a stock or asset once its price reaches a certain level. The goal is to minimize potential losses by exiting the investment when the price drops to a predefined threshold.
For example, if you are Claudia and you bought that Apple stock at $228, you might set a stop-loss order at $220. If the stock price falls to $220, the stop-loss order triggers a sale, protecting you from further losses.
How Does a Stop-Loss Order Work?
Here’s a step-by-step breakdown:
- Choose a Stop Price: Decide the price at which you want the order to trigger.
- Set the Order Type: Stop-loss orders convert to market orders once the stop price is reached, meaning your asset will sell at the next available market price.
- Monitor Your Investment: After placing the order, it remains active until the stop price is reached or you cancel it.
Types of Stop-Loss Orders
- Standard Stop-Loss Order: Triggers a market order to sell once the stop price is hit.
- Stop-Limit Order: Combines a stop-loss and a limit order. It triggers a sale at a specific price or better, giving you more control but no guarantee of execution.
Why Use a Stop-Loss Order?
- Protects Your Capital: Prevents significant losses by limiting downside risk.
- Eliminates Emotional Decisions: Automates the sell process, helping you stick to your investment strategy.
- Improves Discipline: Encourages consistent risk management practices.
Limitations of Stop-Loss Orders
While stop-loss orders are useful, they’re not foolproof:
- Market Volatility: A sudden price drop (e.g., during a flash crash) can trigger the sale even if the price quickly rebounds.
- Execution at Market Price: The final sale price might differ from your stop price, especially in fast-moving markets.
When Should You Use a Stop-Loss Order?
- When you’re investing in volatile markets.
- If you can’t monitor your portfolio regularly.
- To lock in profits by setting a stop price above your purchase price.