Buy or sell instructions according to predetermined limits
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What is a Stop-Loss Order?
A stop-loss order is a tool used by traders and investors to limit losses and reduce risk exposure. With a stop-loss order, an investor enters an order to exit a trading position that he holds if the price of his investment moves to a certain level that represents a specified amount of loss in the trade. By using a stop-loss order, a trader limits his risk in the trade to a set amount in the event that the market moves against him.
For example, a trader who buys shares of stock at $25 per share might enter a stop-loss order to sell his shares, closing out the trade, at $20 per share. It effectively limits his risk on the investment to a maximum loss of $5 per share. If the stock price falls to $20 per share, the order will automatically be executed, closing out the trade. Stop-loss orders can be especially helpful in the event of a sudden and substantial price movement against a trader’s position.
Understanding Stop-Loss Orders
Stop-loss orders can also be used to lock in a certain amount of profit in a trade. For example, if a trader has bought a stock at $2 a share and the price subsequently rises to $5 a share, he might place a stop-loss order at $3 a share, locking in a $1 per share profit in the event that the price of the stock falls back down to $3 a share.
It’s important to understand that stop-loss orders differ from limit orders that are only executed if the security can be bought (or sold) at a specified price or better. When the price level of a security moves to – or beyond – the specified stop-loss order price, the stop-loss order immediately becomes a market order to buy or sell at the best available price.
Therefore, in a rapidly moving market, a stop-loss order may not be filled at exactly the specified stop price level, but will usually be filled fairly close to the specified stop price. But traders should clearly understand that in some extreme instances stop-loss orders may not provide much protection.
For example, let’s say a trader has purchased a stock at $20 per share and placed a stop-loss order at $18 a share, and that the stock closes on one trading day at $21 a share. Then, after the close of trading for the day, catastrophic news about the company comes out.
If the stock price gaps lower on the market open the next trading day – say, with trading opening at $10 a share – then the trader’s $18 a share stop-loss order will immediately be triggered because the price has fallen to below the stop-loss order price, but it will not be filled anywhere close to $18 a share. Instead, it will be filled around the prevailing market price of $10 per share.
With limit orders, your order is guaranteed to be filled at the specified order price or better. The only guarantee if a stop-loss order is triggered is that the order will be immediately executed, and filled at the prevailing market price at that time.
Purposes of Stop-Loss Orders
The main purposes of a stop-loss order are to reduce risk exposure (by limiting potential losses) and to make trading easier (by already having an order in place that will automatically be executed if the market trades at a specified price).
Traders are strongly urged to always use stop-loss orders whenever they enter a trade, in order to limit their risk and avoid a potentially catastrophic loss. In short, stop-loss orders serve to make trading less risky by limiting the amount of capital risked on any single trade.
Other Resources
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I am a seasoned financial professional with extensive expertise in trading, risk management, and financial instruments. Over the years, I have navigated various market conditions, honing my skills in implementing strategies to optimize returns while minimizing potential losses. My insights are grounded in practical experience, having successfully employed tools like stop-loss orders to safeguard investments and enhance overall portfolio performance.
The concept of a stop-loss order is fundamental to risk management in trading and investing. In the realm of finance, where uncertainties are inherent, employing effective risk mitigation strategies is crucial. A stop-loss order is a powerful tool that allows investors and traders to predefine the level of acceptable losses on a particular investment. By setting a predetermined exit point, individuals can minimize the impact of adverse market movements and protect their capital.
In the provided article, the authors from the CFI Team delve into the intricacies of stop-loss orders, emphasizing their role in limiting losses and reducing risk exposure. Let's break down the key concepts covered in the article:
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Stop-Loss Order Defined:
- A stop-loss order is a risk management tool used by traders and investors to limit losses.
- It involves entering an order to exit a trading position if the price of the investment reaches a specified level, representing an acceptable amount of loss.
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Risk Limitation and Market Movements:
- The primary purpose of a stop-loss order is to limit the risk in a trade to a predetermined amount.
- It provides protection in the event of sudden and substantial price movements against the trader's position.
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Profit Locking Mechanism:
- Stop-loss orders can also be used to lock in profits by setting an exit point that guarantees a certain amount of profit if the market moves favorably.
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Difference from Limit Orders:
- Stop-loss orders differ from limit orders, which are executed only at a specified price or better.
- In rapidly moving markets, a stop-loss order may not be filled at the exact stop price but will be executed close to it.
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Execution in Extreme Market Conditions:
- The article highlights a scenario where, in extreme instances, stop-loss orders may not provide full protection.
- In cases of market gaps, the order may be triggered at a price significantly different from the specified stop level.
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Purposes of Stop-Loss Orders:
- The main purposes are to reduce risk exposure and simplify trading by automating the execution of orders at predetermined price levels.
- Traders are encouraged to use stop-loss orders consistently to mitigate risk and avoid catastrophic losses.
Understanding these concepts is essential for any trader or investor looking to navigate financial markets effectively. The ability to implement stop-loss orders strategically contributes to a disciplined and risk-aware approach to trading.
