What is a Stop-Loss Order?
A stop-loss order (also called a stop order or stop market order) is an order whereby the investor instructs the broker to automatically sell the stock if it drops to a certain price.
How Does a Stop-Loss Order Work?
For example, let's assume that you own 100 shares of Company XYZ stock, for which you have paid $10 per share. You are expecting the stock to hit $12 sometime in the next month, but you do not want to take a huge loss if the market turns the other way.
You direct your broker to set a stop-loss order at $8.50. If the stock goes up, you will realize all of the benefits. If the stock goes down and touches $8.50, your broker will automatically place a market order to sell your shares.
It is important to note that when the stop-loss order is triggered, it becomes a market order. You will not necessarily receive $8.50 per share; you will most likely receive a little more or a little less.
Why Does a Stop-Loss Order Matter?
Stop-loss orders generally are a trading or short-term investing strategy. They are useful because they help reduce the pressure of monitoring your trade day-to-day; the trade is largely set on autopilot. This can be particularly helpful for emotional investors.
Even though stop-loss orders offer crucial trading discipline to investors by helping them make important decisions about cutting losses, they also increase the risk of getting out of a position too early -- especially when volatile stocks are involved. In our example, if XYZ was known to be volatile and fluctuated from $8.00 to $12.50 during the one-month forecasting period, then you would miss out on the price appreciation that you expected.
Long-term buy-and-hold investors probably don't want to make substantial use of stop-loss orders. When a stock goes lower, stop-loss orders will lock in losses rather than give you a chance to evaluate whether a slight price decline is actually signaling a buying opportunity.