Markets can move quickly, and maximising profit while minimising loss in volatile markets is a key part of successful trading. A stop-loss order helps you to do just that – enabling you to decide a point at which the level of loss becomes unacceptable to you. If the market reaches this point, your stop will be triggered and your position closed.
How a stop-loss order works
A stop-loss order works by pulling the plug on your trade if it loses you a certain amount of money – an amount that’s set by you at the outset.
For example, let’s say you own 100 shares in a company, which you bought at 370p each. But the share price has declined to 350p. Though you hope this is a temporary blip, you decide to place a stop-loss order at 320p, to cut your losses if the price drops any further.
The price does keep declining to 270p, but your stop is triggered at 320p and your position is closed. You have lost £50 (100 x 50p), but without your stop you would have been faced with a potential loss of £100 or more. Attaching a stop has prevented your losses increasing beyond the point you are comfortable with.
If the price had recovered before it hit 320p, your stop would never have been triggered and your position would still be open.
Potential drawbacks to stops
However, say that this decline had been temporary, and the market had risen again after hitting 320p. You could have lost out on potential profit, as your stop-loss order would have closed the trade before it returned to profit.
Using a stop-loss strategy can help you identify the right places to put stops to ensure your trades are reaching their potential, while helping to protect you against escalating losses.
Another potential drawback to using a basic stop is slippage. Certain conditions may cause the market to ‘gap’, jumping from one price to another, and this volatility may mean it is not possible to place your trade at the level requested. In this situation, your stop will be closed at the best available price, but you may risk losing more money than you had anticipated – this is known as slippage.
Say that the shares (in the example above) closed on Friday at a share price of 330p, but opened again the following Sunday at 310p. Your stop would have triggered at 320p, but your position would have closed at 310p – the next best available price.
Other types of stops
In addition to basic stops, there are other types of stop-losses available to traders. It is important to consider what level of risk you are happy with when selecting which stop to use, as they can work in different ways.
- Guaranteed stops: similar to basic stops, except not affected by slippage. Attaching a guaranteed stop-loss order puts an absolute cap on your potential loss, so that even if the market gaps suddenly, you will have no unexpected loss. If your guaranteed stop is triggered, you’ll have to pay a small premium
- Trailing stops: follow the market if it moves in your favour, and locks if the market moves against you. You’ll need to enter a trailing step that indicates how closely the stop moves behind the market price. For example, if your step size is ten points, then every time the market moves up five points, your stop will move five points to follow it
Stop order vs limit order
A stop-loss order tells your provider to buy or sell an asset at a particular price that is less favourable than the current price. They are the opposite of limit orders, which instruct your provider to buy or sell at a price more favourable than the current price.
While stop-loss orders close positions, it is also possible to open a trade with stops – using a stop-entry order. Opening a trade at a worse price than the current asset price can enable you to take advantage of market momentum.
Any type of stop-loss order – basic, guaranteed or trailing – can be hugely useful as you trade financial markets, but stops should only form a part of your risk management strategy.