Stop-loss order

Stop-loss order
See also
Bear spread Delta neutral Gamma hedging Diagonal spread Slow market Delta neutral strategy Short call option Calendar spread Technical correction

A stop-loss order is an instruction given to a broker to buy or sell a security when it reaches a certain price. It is used to limit the losses on a security position. Typically, a stop-loss order is used to limit the losses on a long position. It works by setting a price point at which the security will be sold if it reaches that level. This prevents further losses if the security drops further.

Example of Stop-loss order

For example, an investor owns 1000 shares of ABC Corporation at $15.00 per share. The investor can set a stop-loss order at $14.00, so that if the stock drops to $14.00 or below, the stop-loss order will be triggered and the shares will be sold. This ensures that the investor's losses are limited to no more than $1000.

In addition to limiting losses, a stop-loss order can also be used to protect gains. For example, an investor buys 1000 shares of ABC Corporation at $10.00 per share. The investor can set a stop-loss order at $12.00, so that if the stock rises to $12.00 or above, the order will be triggered and the shares will be sold. This ensures that the investor's gains are limited to no more than $2000.

To illustrate how a stop-loss order works, consider an investor who owns 1000 shares of ABC Corporation at $15.00 per share. The investor can set a stop-loss order at $14.00, so that if the stock drops to $14.00 or below, the stop-loss order will be triggered and the shares will be sold. This ensures that the investor's losses are limited to no more than $1000.

In this example, if the price of ABC Corporation drops to $14.00 or below, the stop-loss order will be triggered and the shares will be sold, thereby limiting the investor's losses to no more than $1000. Conversely, if the price of ABC Corporation rises to $16.00 or above, the stop-loss order will not be triggered and the investor will continue to hold their shares.

Formula of Stop-loss order

The formula of a stop-loss order is as follows:

Stop Loss Order = Current Price - (Maximum Loss / Number of Shares)

Where,

• Current Price = The current price of the security
• Maximum Loss = The maximum amount of loss the investor is willing to take
• Number of Shares = The number of shares owned by the investor

When to use Stop-loss order

Stop-loss orders can be used in a variety of situations, such as:

• When an investor is holding a long position and wants to protect against a sharp decline in the price of the security.
• When an investor is holding a short position and wants to protect against a sharp increase in the price of the security.
• When an investor wants to protect against a sudden change in the market sentiment.
• When an investor wants to lock in profits from a profitable trade.

Types of Stop-loss order

• Market Order: A market order is an order to buy or sell a security at the best available price in the market. This type of order is used when an investor wants to be sure that the order will be filled as soon as possible.
• Limit Order: A limit order is an order to buy or sell a security at a specified price or better. This type of order is used when an investor wants to ensure that their order will only be filled at a certain price or better.
• Trailing Stop-Loss Order: A trailing stop-loss order is an order to buy or sell a security if it moves a certain percentage away from its current price. This type of order is used when an investor wants to take advantage of a trend in a security’s price.

Steps of Stop-loss order

• First, an investor decides on the maximum losses they are willing to accept on a security.
• Second, the investor will place a stop-loss order with a broker at a price that is lower than the current market price.
• Third, if the security drops to the stop-loss price or below, the order will be triggered and the security will be sold.

Advantages of Stop-loss order

• Control of risk: Stop-loss orders allow investors to control their risk by limiting losses or protecting gains.
• Automation: Stop-loss orders are automated and will be triggered as soon as the price reaches the specified level. This eliminates the need for investors to constantly monitor their positions.
• Discipline: Stop-loss orders help investors remain disciplined and stick to their investment strategies.

Limitations of Stop-loss order

Stop-loss orders have several limitations that investors should be aware of. Here are the main limitations of stop-loss orders:

• Price Gaps: Stop-loss orders are not executed if the price of the security gaps down or up. Gaps occur when the stock price moves significantly between the close of one trading session and the open of the next. This can cause the stop-loss order to be triggered at a price significantly different from the desired price.
• Slippage: Slippage occurs when the price of the security moves before the stop-loss order can be executed. This can result in the order being executed at a price other than the desired price.
• Market Volatility: In times of high market volatility, stop-loss orders may not be executed at the desired price due to sudden and unexpected price movements.

Other approaches related to Stop-loss order

• Trailing Stop-Loss Order: A trailing stop-loss order is an order to buy or sell a security when it reaches a certain price, but with the added feature that the price is adjusted as the stock's price moves. For example, if an investor owns 1000 shares of ABC Corporation at $15.00 per share, they can set a trailing stop-loss order at $13.00. If the price of the stock moves up to $16.00, the stop-loss order will be triggered when the stock drops to $14.00. The trailing stop-loss order can be used to protect gains as the stock's price increases.
• Stop-Limit Order: A stop-limit order is an order to buy or sell a security when it reaches a certain price, but with the added feature that the order will only be executed at a specific price or better. For example, if an investor owns 1000 shares of ABC Corporation at $15.00 per share, they can set a stop-limit order at $13.00 with a limit of $14.00. If the stock drops to $13.00, the order will only be executed if the stock trades at $14.00 or higher. This order can be used to ensure that the investor's losses are limited to a certain amount.

Suggested literature

• Osler, C. L. (2005). Stop-loss orders and price cascades in currency markets. Journal of international Money and Finance, 24(2), 219-241.
• Dhaene, J., & Goovaerts, M. J. (1996). Dependency of Risks and Stop-Loss Order1. ASTIN Bulletin: The Journal of the IAA, 26(2), 201-212.