Stop Loss Orders Example: Understanding This Trading Strategy

S ometimes called a stop order, a stop-loss order is an advanced tool allowing traders to automatically execute a trade only if the asset in question hits an established price level. This differs from a standard stock-market order, in which the trader buys or sells the specified asset at the current market price. With a stop-loss order, you can potentially limit your loss on a particular trade. Investors who attempt to profit from short-term market changes will benefit most from stop-loss orders. Long-term investors will rarely find a need for this particular strategy.

Key Points:

  • Stop-loss orders allow traders to manage risk by limiting losses for a particular trade.
  • With a stop-loss order, you set a price that triggers a market order when the target security hits that price.
  • The shares in question trade at the stock’s price when the market order goes through, which is not necessarily the same as the trigger price.
  • You can lose out on potential profit if your asset dips down to the stop-loss price and then recovers.
  • Traders typically set the ideal stop-loss price by looking at either the asset’s moving average or support level, though some decide based on how much of their investment they can afford to lose.
  • Pros of stop-loss orders include guaranteed profit, limited loss, a low-monitoring-required approach, and the ability to avoid making overly emotional trade decisions.
  • Potential downsides of stop-loss orders include an early stop-loss trigger, often caused by high market volatility or a stop price that’s not low enough.
  • A trailing stop-loss order allows a trader to capture profit by executing a sale at the highest daily price after the asset hits the stop-loss price.

How Stop-Loss Orders Work

The easiest way to understand how a stop-loss order works is to look at a stop-loss order example. Let’s say you bought 10 shares of Apple stock at $115 per share. Since your purchase, the trading price of the stock rose to $145. You think the Apple shares will keep rising and want to make sure you profit at the peak of the market. To realize this goal, you set a stop-loss order to sell your 10 shares of Apple if they drop below $130. In this stop-loss example, you don’t need to constantly monitor the market to protect your position.

Usually, the trigger price for a stop-loss is the same as the highest outstanding bid price for a stock. In this stop-loss sell order example, the shareholder would sell the stock when it hits $130. This price would limit your loss while providing a profit of $15 per share, or $150 in this example. However, remember that the trigger price simply issues a market order for the desired number of shares. The buyer will receive those shares at the current market price, which is often but not necessarily the stop-loss price.

Stop-loss orders limit but do not eliminate risk. You still hold the risk of being ‘stopped out’ if your stock hits the stop-loss point when you don’t actually want to sell. In the stop-loss order example above, if the Apple stock drops below $130, then recovers and exceeds $145, you miss your potential for larger profit after the plunge triggers the sale. You also risk a lower profit than expected if you set the stop-loss price too high.

Traders generally use one of three different methods to land on an ideal stop-loss order price:

  • With the moving average method, you find the moving average for a long-term period and then put your stop price just below that level. For example, if a stock has a moving average of $95 over the last month, put your stop price order at $94.
  • If you prefer to use technical indicators for your trades, try the support method. With this technique, you find the support level for your target stock and use that level as the stop-loss price.
  • The percentage method simply goes by the value you would be comfortable losing. For example, if you can stand to lose 5% of your holdings of a stock that is trading at $50, set your stop-loss price at $37.50.

Pros of Stop-Loss Orders

Advantages of using stop-loss orders include:

  • The guaranteed profit and limited loss created by the stop-loss price.
  • The lack of additional transaction fees for a stop-loss order compared to a traditional market order.
  • The ability to take a set-it-and-forget-it approach to a specific transaction, eliminating the need for constant monitoring.
  • The removal of emotion from the trading process, which can sometimes lead to unwise market moves.

Going on vacation? Too busy to check your portfolio every hour? The stop-loss order might be your new best friend.

Disadvantages of Stop-Loss Orders

Some of the reasons to think twice before placing a stop-loss order include:

  • You are trading a high-volatility stock, which can result in an unwanted price trigger.
  • You can limit your gains if you set a stop price higher than the realized sales price.
  • You have concerns about the risk of early activation of your stop-loss order.
  • Restrictions on stop-loss orders; for example, many brokerage firms have rules about using stop orders on some asset classes, usually over-the-counter and penny stocks.

Let’s look at a stop-loss order example that actually occurred in real life. This example epitomizes the risk associated with an unexpected stop-loss trigger. When the market suffered a flash crash in May 2010, hundreds of New York Stock Exchange securities dropped in value by more than 20%, triggering hundreds of stop-loss orders and jamming the trading desks.

The affected stop-loss orders were eventually filled at prices well below the trigger prices, even though many of the securities recovered within hours. As reported by the Wall Street Journal on May 15, 2010, one management consultant had a standing stop-loss order for $49.17 per share. His order was activated but did not execute until the shares hit $41.15, resulting in the loss of more than 18 months of capital. The fund in question, the Vanguard Total Stock Market ETF, closed for the day all the way back up at $57.71 per share.

In this example of a stop-loss order, the trader ended up losing $8.02 per share from the stop-loss price. Had he not placed a stop-loss order, he could theoretically have instead sold the shares at the closing price for a profit of $8.54 each.

Using a Trailing Stop-Loss Order

Image via Flickr by Jim Makos

T his special type of stop-loss order has an adjustable rather than fixed trigger price. With this stop-loss order example, you set a trailing stop-loss price, which means it trails (falls under) the asset’s price by a certain amount, often a specified percentage. Like a stop-loss order, this scenario allows you to guarantee profits, but it also ensures that your order will take advantage of a rising share price. A trailing stop-loss order will always take place at the highest daily price for the stock in question.

Let’s look at a stop-loss example with a trailing price. In this scenario, you buy a target stock at $20 per share and establish a 5% trailing stop-loss order. With this stop-loss order example, your sell order will be triggered when the stock price hits $19. However, instead of automatic execution as with a traditional stop order, the order does not take place until the stock hits its highest daily price. In this example, the sale would take place at $19 per share even if the stock drops further and at $30 per share if that’s the peak trading price of the day.

These stop-loss order examples should give you the primer you need to try this strategy for yourself. Some experts recommend that all short-term traders get in the habit of setting a stop-loss to mitigate risk and optimize the potential for profits.