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How does a stop loss order work
Is it as simple as saying Stop! and that's it?
Regardless of whether you are a beginner or pro-trader, it’s always best to understand the several tools that are available to you as a day trader. The extent of your knowledge about the financial markets will give you an edge over traders and help you plan and implement your trading strategy without exposing yourself to avoidable risks.
Speaking of day trading tools and how you can leverage them to protect your business or investments as a day trader, there is such thing as a stop-loss order. If you are just learning about stop-loss order for the first time or you have heard about it and are yet to wrap your mind around it, we shed more light on the often asked question — how does a stop-loss order work?
How does a stop-loss order work?
A stop-loss order, if used properly will save you so many heartbreaks whenever the markets decide to act up and swing against you. In addition to helping to save your account from heartbreaking free-fall, a stop-loss order can make all the difference in your trading career.
While some will argue that a short-term price fluctuation could trigger or activate an unnecessary sale, there will always be more advantages for using a stop-loss order than not using it in your trades.
To help you understand how a stop-loss order works, it will help to know what it is. A stop-loss order is an order that is placed with a brier to automatically buy or sell stocks when a certain price is reached. You can think of it as a safety net. It is designed to help traders limit the extent of a potential loss on their stocks or other financial instruments or securities.
How about we take a look at an example? For instance, you can set a stop loss at 10% below your entry price to long your loss on a specific stock to 10%. Suppose you just bought stock XYZ at $20 per share and you set your stop loss for $15. If the stock price plummets to $15, your shares will immediately be cold at the prevailing market price.
As you would have thought, a stop-loss order is similar to a stop-limit order. However, there is a limit on the price that must be reached before both orders are executed — and that implies that a stop-limit order has two prices: the stop price which converts the order to a sell order, and a limit price. So, instead of executing a sell market order, the sell order becomes a limit order which will only be executed at the limit price.
What are the advantages of the stop-loss order?
Having understood how stop-loss orders work, one other question that is possibly running across your mind is whether a stop-loss order has any advantage. They do. Stop losses are arguably one of the most overlooked tools for new traders and most times not using them is the reason why traders (especially the fledglings) blow their accounts.
At the top of the list of the advantages of a stop-loss order is that it costs nothing to implement. That way, a commission is not charged until the stop-loss price has is hit and the stock is sold. When you think of how a stop-loss order works, you won’t be wrong to think of it as a free insurance policy.
Another benefit of a stop-loss order is that it reduces the significant amount of pressure that comes with the decision-making process in trading. It’s not unusual to find some traders have been emotionally attached to certain stocks to the extent to the extent that they sometimes nurture false beliefs about losing stocks coming around or regaining momentum. As such, they (speaking of the trader) end up incurring mammoth losses.
But that is not all.
Stop-loss orders are also applauded for their flexibility. They are of benefit to virtually all types of traders including value investors, growth investors, and active day traders. So, it doesn’t matter what your trading strategy is, you will always find a stop-loss order helpful in protecting your investments while raking in decent profits.
Having mentioned that, it’s worth mentioning that using a stop loss order doesn’t guarantee that you will become a successful trader. Recall that a stop-loss order is a tool that is designed to complement your decision. So, if you make the wrong calls, you will still end up losing money as you would without using a stop-loss order (however, the magnitude of the loss will be lower).
How to Place a Stop-Loss
There are two ways to place your stop-loss order. One is via a stop-limit order and the other is a stop market order. The wording may differ depending on your broker but the way it works is the same. With a stop-limit order, you will place a price point that will trigger the order to go live. This will set a limit price you want it filled at.
Trigger $99.50 with a limit of $99 this means if the price hits $99.50 your order will go live and will only fill at $99 or above. The danger with this is that if it hits $99.50 and flashes quickly through $99. You might not be filled and the stock could see a further downside with your order still sitting live not being filled. This is when a stop market order wins because if you set the stop at $99 and it hits $99 you will be filled. This is great because you will be filled at the best market value after the trigger. The downside is that this price could be $99 or $98 or $100 or $85! Slippage is a possibility but at least you will be out of the trade right then and there.
Stop-loss orders can also be used to lock in profits
Yes, you read that right. Indeed, stop-loss orders are traditionally intended to prevent losses. However, they can also be used to lock in profits, and in such situations; a stop-loss order is referred to as a trailing stop. How does it work?
While using a stop loss as a trailing stop involves continually adjusting your stop loss at the price e of the stock or whatever instrument you are trading progress in the direction you want it to. So, if the stock prices have gained in your desired direction, you can start by moving your stop loss to your entry price and continue to adjust the stop loss as the stock price head for its target or take profit.
So, if the price was to fluctuate and go in the other direction, you would have already locked in some profits. That way you exit the market with less profit instead of taking the “L”.
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