What is a stop loss?
Stop Loss refers to the term used when executing a Stop Loss order. Typically, the term “stop loss” is used when a trade incurs losses by reaching a user-defined trigger point to execute a market order to protect the trader’s funds. This exit transaction can be triggered automatically or manually. The phrase can also be used to describe what happens to a trader who sets a trailing stop to take profits from long-term trend trades. In this case, the trade may actually be profitable, but the exit stops those profits from evaporating.
- Stop loss is a phrase that usually means that a trader must close a position at a loss on a stop loss order.
- The phrase can also refer to a long-term trade that exits at a profit by using a trailing stop that is triggered after a sudden price pullback. In this case, it may not mean a loss.
- Options or other forms of hedging can be used as an alternative to stop-loss orders.
How Stop Loss Works
The term stop loss refers to exiting a position. In most cases, the exit will be achieved through the use of a stop loss order. This order is an effective tool to limit potential losses, even if they are executed unexpectedly during periods of high volatility. Many times the term “stop loss” is used in a negative sense when a trader’s position is accidentally sold because it means that the trader has incurred a loss.
Traders can be stopped when they are long or short in any type of security for which a stop loss order can be placed. Day traders in the stock, options, and index futures markets often use such orders or their equivalent manual techniques.
Traders are often stopped out when the market wobbles, or move sharply in one direction before returning to its original state. For example, stocks may fluctuate during earnings announcements or other market-moving events.
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While earnings announcements are usually made before or after trading hours, the same situation could play out on two different trading days. Many traders try to avoid unnecessary stops by employing one or more techniques. Traders have several different options to avoid getting stopped out, but none of them are risk-free.
The first is the use of psychological stops, which means they keep the stop price in mind rather than placing an actual order. By doing this, the trader can avoid being stopped out during the wash. The risk is that the sell-off never happens and the stock continues to move in the wrong direction. When they finally got out of the trade, the losses were worse than they could have been. In many ways, psychological stops defeat the entire purpose of using stops to reduce risk, as there is no guarantee that a trader will remember or choose to actually sell a stock.
Another technique is to use options or other forms of hedging as an alternative to stop-loss orders. For example, by using put options, a trader can hedge a stock position without actually selling the stock. A trader who owns 100 shares can buy put options on those shares with a strike price equal to the desired stop loss. Option trades will prevent a decline if the stock is washed out without selling the stock prematurely.
Stop Loss Example
Suppose a trader buys 100 shares at $100 per share and sets a stop loss at $98 and a take profit order at $102 ahead of the key earnings announcement. Also assume that earnings announcements happen on the trading day (which is rarely done these days). After the earnings report, imagine a sharp drop in the stock price to $95, then a quick recovery to $103. Unfortunately for traders, they would have been stopped out.
If the stock falls in an orderly manner to $95, all the way lower, traders will place a stop loss order at $98. However, even if the price immediately fell straight to $95, the trader would not only be stopped out, but would have to accept a price of $95 instead of $98.