What is the meaning of a stop-loss order?
A stop-loss order is an essential factor that a trader should not forget to consider when trading. It avoids losses when a trader instructs the broker to sell the order automatically when hitting a specific price.
An example scenario with a stop-loss order
Laura is a busy mother of two but is also really into trading. She suddenly got interested in buying stocks with Z Company. Laura decided to buy a total of 500 stock shares at $50 from Z Company. After reading some more articles about the company, she gets convinced that there will be a price increase in the coming weeks. However, she is not 100% sure about it. After all, it is just anticipation at the end of the day. Like any other trader, she does not want to risk losing a lot.
Now, Laura thought of a way to avoid this potential loss. She contacts her broker and tells him to place a stop order at $45. If the odds favored Laura and the stocks skyrockets then, she goes home with a considerable return. However, if things go the way Laura does not want it to and the stocks declined to the point that it hits $45, the stop order converts into a market order that will sell Laura’s shares to avoid losses.
This occurrence is what we mean previously when we say that stop-loss order is an essential factor that any trader should not forget to consider. It saves a trader from any distress because of significant losses. In this case, if the situation calls for Laura to sell her shares, then she will not receive exactly $45. She will receive something with a discrepancy, but it should still be something close to $45.
More on stop-loss orders
We can say that the market will always be volatile in our previous discussion, and nobody can predict it. In the case of Laura, at first, she was expecting that the price would increase. If it decreased due to unforeseeable events, then the stop order did something beneficial for her without even exerting too much effort to pay the trade her full attention. It is all automatic.
The downside of a stop-loss order
However, there are also times when stop-loss orders subject the trader to an exit that is way too early. For example, even though Laura anticipated a future price increase, sometimes, there are sudden price drops and fluctuations. This price drop will cause the automatic execution of Laura’s order. Even if the price drop is just for a short period, and then there is a massive price increase afterward, the execution already took place. It leaves Laura the fact that she missed her much-anticipated price increase and potential high gains. That is why some traders do not want to use stop-loss orders, especially if they have time to closely watch over their assets and instead choose a long-term buy and hold strategy.