A stop loss order is an order that is placed with a broker because a stock has reached a certain price. This is basically designed to limit the loss that an investor might suffer on a position in a security. A lot of investors associate stop loss order with long position, but it is important to know that it can be used as a short position. In such a case, the security is bought if it is above the given price.
The stop loss order is very effective since it takes out all the emotions when it comes to taking trading decisions. However, these executions are not always guaranteed especially where the trading in stock is halted, which is also known as a stop market order.
In order to understand the concept, let’s use an example. If you set up a stop loss order for 10% below the price at which you buy the stock, your loss will be limited to 10%. So if you buy an Apple stock for $10 per share, your stop loss order will be $9. This would mean that if the stock’s price falls below $9, the shares will be sold at the market price that will be prevailing at that moment.
Advantages and Disadvantages of Stop Loss Order
One of the biggest advantages of stop loss order is that you can be stress free, because you won’t have to see how the stock is performing on a daily basis. This can come in handy when you are on a leave or on vacation where you can’t watch your stocks.
Because every coin has two sides, stop loss order has disadvantages too. The stop price can get activated even if there is a small term fluctuation in the stock’s price. In order to overcome this, one needs to set a stop loss percentage that will allow the stock to fluctuate and will prevent downside risk to a great extent. Once your stock price is reached, the stop order will become a market order and the price that you will sell at might be a little different than the stop price.
Further Reading
- Stop-loss orders and price cascades in currency markets – www.sciencedirect.com [PDF]
- On immunization, stop-loss order and the maximum Shiu measure – www.sciencedirect.com [PDF]
- The stop-loss start-gain paradox and option valuation: A new decomposition into intrinsic and time value – academic.oup.com [PDF]
- The causal effect of stop-loss and take-gain orders on the disposition effect – academic.oup.com [PDF]
- When do stop-loss rules stop losses? – www.sciencedirect.com [PDF]
- On stop-loss order and the distortion pricing principle – www.cambridge.org [PDF]
- Higher degree stop-loss transforms and stochastic orders—(i) theory – link.springer.com [PDF]
- Distortion risk measures and economic capital – www.tandfonline.com [PDF]
- Stop loss reinsurance [J] – en.cnki.com.cn [PDF]
- Risk measures with comonotonic subadditivity or convexity and respecting stochastic orders – www.sciencedirect.com [PDF]
