What is a Stop-Loss Order? Definition & How to Use
Learn what a stop-loss order is, how stop orders work, different types of stops, and strategies for protecting your investments from large losses.
What is a Stop-Loss Order?
A stop-loss order (or simply “stop order”) is an instruction to sell a security when it reaches a specified price, designed to limit potential losses. When the stop price is hit, the order becomes a market order and executes at the next available price.
How Stop-Loss Orders Work
- You own stock currently trading at $100
- You set a stop-loss at $90
- If price drops to $90, order triggers
- Order becomes market order and executes
- You exit position, limiting loss to ~10%
Types of Stop Orders
Standard Stop-Loss
- Triggers at stop price
- Becomes market order
- Executes at next available price
Stop-Limit Order
- Triggers at stop price
- Becomes limit order (not market)
- Only executes at limit price or better
- Risk: May not fill if price gaps through
Trailing Stop
- Stop price moves with market
- Maintains set distance from peak
- Locks in gains as price rises
Stop-Loss Examples
Basic Stop-Loss
| Position | Stop Level | Outcome |
|---|---|---|
| Bought at $100 | Stop at $90 | Maximum ~10% loss |
Stop-Limit
| Position | Stop | Limit | Risk |
|---|---|---|---|
| Bought at $100 | Stop $90 | Limit $89 | Won’t sell below $89 |
Trailing Stop ($5)
| Price Movement | Stop Level |
|---|---|
| Bought at $100 | Stop $95 |
| Price rises to $110 | Stop rises to $105 |
| Price rises to $120 | Stop rises to $115 |
| Price drops to $115 | ORDER TRIGGERS |
When to Use Stop-Loss Orders
Good For:
- Limiting downside: Protecting against large losses
- Disciplined exits: Removing emotion from sell decisions
- While away: Protection when not monitoring positions
- Volatile stocks: Managing higher-risk positions
Less Ideal For:
- Long-term investors: May trigger on normal volatility
- Illiquid stocks: May fill at poor prices
- Extremely volatile stocks: Frequent stop-outs
Where to Place Stop-Losses
Common Methods
| Method | Example |
|---|---|
| Percentage | 5-10% below purchase price |
| Support level | Just below technical support |
| Volatility-based | 2× average daily range |
| Dollar amount | Maximum loss you can accept |
Example: Support-Based Stop
- Stock at $100
- Support level at $92
- Place stop at $91 (just below support)
Problems with Stop-Losses
1. Whipsaws
Price drops, triggers stop, then rebounds. You sell at the worst time.
2. Gap Risk
Stock opens significantly below stop (earnings, news). May fill far below stop price.
3. Stop Hunting
Market makers or algorithms push price to common stop levels, then reverse.
4. Flash Crashes
Brief extreme price drops trigger stops at terrible prices.
Stop-Loss Order vs. Mental Stop
| Type | Pros | Cons |
|---|---|---|
| Actual Stop Order | Automatic, removes emotion | Visible to market, whipsaws |
| Mental Stop | Flexible, invisible | Requires discipline, may hesitate |
Trailing Stop Strategy
Trailing stops are useful for:
- Letting winners run
- Locking in profits
- Automatic profit-taking
Trailing Stop Types
| Type | Description |
|---|---|
| Dollar Amount | Stop trails by $X (e.g., $5) |
| Percentage | Stop trails by X% (e.g., 10%) |
| ATR-Based | Stop trails by volatility measure |
Stop-Loss Best Practices
- Don’t place too tight: Normal volatility will trigger stops
- Account for spreads: Especially in less liquid stocks
- Review regularly: Adjust as position and market change
- Consider alternatives: Options for downside protection
- Don’t over-rely: Part of strategy, not the whole strategy
Alternatives to Stop-Losses
| Alternative | Description |
|---|---|
| Put options | Guaranteed floor price |
| Position sizing | Smaller positions = less risk |
| Diversification | Spread risk across holdings |
| Hedging | Offsetting positions |
Related Financial Terms
This glossary entry is for educational purposes only and does not constitute investment advice.