Most investors have heard of stop-loss orders, but many don’t use them because they don’t understand how they work. A stop-loss order is an order placed with a broker to buy or sell a security when it reaches a certain price.
The investor sets the stop price, which is the price at which the order will be triggered.
A stop-loss order is designed to limit an investor’s loss on a security position. For example, suppose an investor buys stock in Company XYZ at $50 per share and places a stop-loss order at $45 per share.
If the price of XYZ falls to $45, the stop-loss order will be triggered and the stock will be sold at $45. The stop-loss order protects the investor from a larger loss if the price of XYZ falls further.
Stop-loss orders are not foolproof, however. In fast-moving markets, it’s possible for the price of a security to fall so quickly that the stop price is never reached and the order is not triggered.
This is known as a “gap down.” Another risk is that the stop price may be reached and the order triggered, but then the price may rebound quickly, resulting in a smaller loss than would have been incurred if no stop-loss order had been placed.
Despite these risks, stop-loss orders can be useful tools for investors who want to limit their losses on a security position.