A stop-loss is a risk management tool used by traders to limit their losses on a particular trade. It is an order to sell a security when it reaches a certain price level, which is specified by the trader. When the stop-loss order is triggered, it automatically closes the trade, helping the trader to limit their losses.
Stop-loss orders are used in trading to minimize the potential loss on a trade. They are typically placed below the entry price for long positions and above the entry price for short positions. The idea is that if the market moves against the trader, the stop-loss will be triggered, and the position will be closed before the losses become too large.
To use a stop-loss in trading, the trader first needs to decide on the level at which they want to place the order. This is typically based on the trader’s risk tolerance and the volatility of the market. For example, if a trader is willing to risk 2% of their account on a trade, they may set the stop-loss at 2% below the entry price.
How to use stop loss order in a sample
Let’s say you bought 100 shares of ABC stock at $50 per share, for a total cost of $5,000. You’re worried that the stock might drop in value, so you decide to set a stop loss order at $45 per share.
This means that if the stock drops to $45 per share or lower, your broker will automatically sell your shares to limit your potential losses.
To calculate the potential loss you could face without a stop loss order, you can use the following formula:
Potential loss = (original price – stop loss price) x number of shares
In this case, the potential loss without a stop loss order would be:
Potential loss = ($50 – $45) x 100 = $500
So if the stock dropped to $45 per share without a stop loss order, you could potentially lose $500.
However, with a stop loss order at $45 per share, your potential loss is limited to:
Potential loss = (stop loss price – original price) x number of shares
In this case, the potential loss with a stop loss order would be:
Potential loss = ($45 – $50) x 100 = -$500
Note that the result is negative because the stop loss order would trigger a sale of your shares at a lower price than what you originally paid for them. However, this loss is limited to $500, which is the maximum amount you’re willing to risk.
Once the stop-loss level has been decided, the trader places the order with their broker. The stop-loss order can be a market order or a limit order. A market order will be executed immediately when the stop-loss level is reached, while a limit order will be executed only if the price is at or better than the specified level.
It is important to note that stop-loss orders are not a guarantee of avoiding losses. In a fast-moving market or in times of extreme volatility, the price may move beyond the stop-loss level, and the order may be executed at a worse price than the trader intended. Therefore, it is essential to monitor the markets closely and adjust the stop-loss order as necessary.
In summary, a stop-loss order is a risk management tool used by traders to limit their losses on a particular trade. It is an order to sell a security when it reaches a certain price level, specified by the trader. Stop-loss orders can be used to help traders minimize their losses and manage their risk in trading.