A common fear people have about investing is that it’s gambling. They think they would lose on average. But that’s not the case and investors who lose often have a common trait—they don’t know when to leave the game. Having an exit strategy is important, and a stop loss order can be a crucial part of that strategy. Designed to minimize losses and possibly lock in gains, stop loss orders can be an investor’s best friend.

What is a Stop Loss Order?

A stop loss order is a command to sell a security at a certain price. The goal is to Limit an investor’s loss on a security’s position. The investor will set a price below the purchase price. If the security falls on or below that price, the order to sell will be executed. This can help prevent the investor from an even greater loss. But like most things in investing, it isn’t always a guarantee.

There are three main types of stop loss orders:

• Stop Loss Market Order
• Stop Limit Order
• Trailing Stop Loss Order

Each type of order has its own strategy. Let’s look at what they are and how they can help your investment portfolio.

Stop Loss Market Order

This is your standard stop loss order. The reason “market” is included in the name is because of its function. When a security reaches your stop loss price, it becomes a Market order to sell the security at or below the price. This is ideal for traders who don’t want to manually watch and exit the market. And more times than not, loss is minimal. But it isn’t guaranteed that the security will sell at the exact price. This is especially true in a fast-paced market or when major news has come out. Here’s an example with two possible outcomes…

You purchase 100 shares at $50 each. You set a stop loss order for $40. This means if the price of the shares falls to $40 or below $40, a market order will be executed to sell them.

Ideally, the share price falls and hits $40. The order is triggered, and the shares are sold at $39.95. Your loss is effectively minimized, and you avoided a possible devastating lost.

Worst case scenario let’s say the company was exposed for fraud. Their stock tanks. When the market re-opens, the stop order is triggered, but the securities are sold at a mere $5. With 100 shares, that’s a total loss of $4,500. This issue is known as slippage.

Stop Limit Order

A stop limit order trades securities at the stop price or better. Since the stop Loss Market order takes any price at or below the stop, a stop limit can avoid slippage. But it leads to a greater problem. If the market is moving aggressively and it’s moving against you, you don’t get out of the market. Stop limit orders have two prices: the stop price and the limit price.

Let’s say you have those 100 shares you bought at $50 each. You set a stop price at $45. This means if the price drops to $45, the order will be triggered. You set a limit price of $40. This is the lowest price you’re willing to sell your shares.

Ideally, the price hits $45 and triggers the order. If the price is within that $40-$45 range after the trigger, the shares will be sold. This minimizes your loss to between $500 and $1,000.

Worst case scenario is an aggressive market drops the share price to $35. Although the price is below the stop, it isn’t above the limit. So, the order is never fulfilled. Without the order being filled, your loss continues to grow the further it falls. And you hope the price recovers.

Trailing Stop Loss Order

A trailing stop is a stop loss order set to a certain percentage below the market price. As the security price increases, so does the stop price. But the stop price doesn’t move if the price drops. So, a trailing stop loss can further limit losses and even lock in gains. But trailing stops aren’t always a guaranteed win. Let’s look at how it can play out.

For your 100 shares, you set a 25% trailing stop. Since you purchased them for $50, that would make your original stop price $37.50. But the company does well, and their value goes up. Your shares go from $50 to $80. Because trailing stops move with an increase in price, your stop price is now $60. If the stock price then falls to $70, the stop price stays at $60.

Ideally, once the price hits $60, the order is triggered. Your shares sell for $60 each, and you make a profit of $1,000.

Worst case scenario is the stock price jumps right over your stop price. The order then acts as a standard stop loss order. The shares are sold for whatever the market price is after the order is triggered. If we take the same scenario as the stop loss market order, your shares are sold for $5 apiece for a loss of $4,500.

Note that you shouldn’t set your stops too close to market prices. No stock moves up in a straight line. Having a tight stop price can lead to selling a winning stock while it’s going through normal market price swings.

Stop loss orders are an effective and easy way to help minimize loss. For more information on how to manage risk, check your position sizing with our Position Size Calculator. And don’t forget to sign up for our free e-letter below! More informed decisions lead to better investing.

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