Stop-Loss Order Basics

What is a Stop-Loss Order?

A stop-loss order is an instruction or set of instructions that an investor issues to his broker telling the broker at what price a given stock should be sold should share prices begin to fall. The market price at which the stock is to be sold is called the 'stop price.' The purpose of a stop-loss order is to minimize one's losses. Investors also have the option of issuing both a higher and a lower stop order.

Purpose of a Stop-Loss Order

The prime objective of a stop-loss order is to control investor loss due to falls in market share prices. In other words, a stop-loss order allows the investor to determine how much risk he or she is willing to take on a given stock; by issuing a stop order, investors in essence control the amount of money they could lose if share price falls. When the stock hits the predetermined 'stop price,' the broker knows to automatically sell the stock.

Stop-Loss Order Advantages

•- Investors area able to minimize and control their losses

•- Investors needn't constantly monitor the stock market since they have already predetermined the sell price for their stock

•- Emotionally based decisions stemming from stock market fluctuations are reduced

•- Issuing a stop-loss order do not cost investors extra money

•- A highly recommended tool, especially for beginner investors, to limit potential losses

Stop-Loss Order Disadvantages

•- requires some knowledge of how stock prices rise and fall

•- requires that an investor have a long-term vantage point and not fall prey to short-term fluctuations of stock market values

•- not an ideal strategy for highly volatile stocks, the prices of which fluctuate daily

Trailing Stop Orders

Another benefit of stop-loss orders is that they can be used to not only cap losses but to lock in profits as well. Using what is called a trailing stop order, the stop order is set up to change over time, thereby 'trailing' the market price. For example, after buying stock shares at one price, a stop-loss order can be issued such that if a stock price rises, the price of the stop-loss order rises as well, in accordance with the market price. Hence a trailing stop order is a special type of stop-loss order that both limits investor losses when shares devalue, and allows for maximum investor gain when shares increase in value.

Trailing stop orders can also be used to buy stocks. In such cases, the investor determines how much a given stock price must rise before the broker buys it. This allows the investor to pounce on stocks that are rebounding from their low points.