When the market is dropping at a rapid rate, you might not have time to execute a sell order as you would like in order to limit your losses. In fact, there have been instances where investors don’t even realize that they are piling up the losses until it’s too late and the losses are too large. If you want to avoid losing too much to a stock market drop, a stop loss order can help you manage your portfolio.
What is a Stop Loss Order?
Simply put, a stop loss order is an order that you place at the same time that you buy an investment or enter a trading position (it can also be placed after you make your purchase). The stop loss order specifies that your investment be sold, or your position exited, when a certain level is reached.
When you buy a stock for $25 a share, you might specify that it be sold automatically when it drops to $21 a share. That way, you limit your losses if the stock should fall even further. Stop loss orders are particularly popular with day traders, as well as traders of some of the “riskier” assets, such as currencies.
Advantages of a Stop Loss Order
With a stop loss order, you have the advantage of knowing that you will only use a specific amount of money on your investment. You don’t have to try to monitor the asset performance as often, waiting for the time to sell. This can be helpful if you have other things to take care of, or if you are on vacation. If you want to limit your losses, ensuring that you lose no more than you are comfortable with, a stop loss order can be a great help.
Disadvantages of a Stop Loss Order
Of course, you also run into certain disadvantages with a stop loss order. In some cases, there are short term fluctuations in price. If you have a stop loss order set, it could be triggered if the asset price hits a certain level. However, if the price bounces back higher, you miss the ability to take advantage of the change, since you have already exited your current position.
Also, you have to remember that you will be charged transaction fees. These fees can add up to take a huge bite out of your real returns if your stop loss order is small enough that it regularly triggers transactions. Before you make a stop loss order, it’s important that you check the fluctuations in the market. An asset that fluctuates 12% over the course of a week on a regular basis should not have a stop loss order set for when the asset loses 10% of its value. Instead, the stop loss order should take into account the historical fluctuations; consider setting such a stop loss order for when the asset loses 15% to 18% of its value.
Be aware that even though you set a stop loss order for a certain price level, it doesn’t mean that you will receive that price. The stop loss oder merely triggers a market order. This means that by the time everything clears, your asset might end up settling for a price that is below your stop loss order. It’s vital to understand this going in. A stop loss order is not the same thing as a guarantee that you will get no less than a certain amount.
A stop loss order can be used to your advantage if you are careful about how you set it up. Many investors decide to wait to set a stop loss order until after their assets have appreciated to a certain point. If you wait for this event, you can set a stop loss order that triggers when your asset reaches your original buying price, or a very little below. A stop loss order can also help you avoid losing more than you are comfortable losing on an asset. The automatic stop loss order helps you limit your losses, even when you are in no position to execute an order yourself.
Photo credit: Wikimedia Commons.
Miranda is a professional personal finance journalist. She is a contributor for several personal finance web sites. Her work has been mentioned in and linked to from, USA Today, The Huffington Post, The San Francisco Chronicle, The New York Times, The Wall Street Journal, and other publications. She also has her own personal finance blog: Planting Money Seeds.