What is a stop-loss order?

What you’ll learn:

• How a stop-loss order works.
• How this may be used to lock in profits or reduce losses.
• What some of the disadvantages of a stop-loss order are.

Periods of stock market volatility provide a stark reminder that investments can move down as well as up, sometimes with alarming speed.

One way for investors to protect themselves from any sudden market setbacks is to consider using a stop-loss order, enabling them to automatically sell shares at a set price they’ve determined. Investors can also set a stop loss to retain a profit.

What is a stop-loss order?

The aim of a stop-loss order is to limit an investor’s loss from an investment if that investment falls in value. If the share price falls, the stop order may be triggered automatically, and the holding sold. For example, setting a stop-loss order for 10% below the price at which you bought the stock will limit your losses to 10%.

To take an example of how it might work in practice, let’s say an investor buys a stock at 150p per share, and sets a stop-loss order for 140p. This means that if the stock falls to 140p or less, shares currently held will be sold at the next available market price below this limit, which could be 139p or lower.

Alternatively, an investor may also set a stop order to cement a profit. For example, an investor might buy a share at 150p, and set a stop order at 190p, ensuring profits are retained at this price point. How an investor uses a stop-loss order, of course, depends entirely on their personal preferences, investment goals and attitude to risk.

How a trailing order works

There is another type of stop-loss order, known a ‘trailing stop’, which adjusts automatically to the moving value of the share. This is aimed at protecting gains by allowing a trade to remain open and continue to profit, provided the share price is moving in the investor’s favour. However, it will close the trade if the price changes direction by an amount set by the investor.

So, for example, imagine an investor purchases a share at 150p and the share price subsequently rises to 200p. They may then decide at this point to place a sell trailing stop order at 10p.

If the share price moved up further to 230p but then started to fall, the trailing stop loss would be 10p less than this at 220p, so once the share price reached this level, the trailing stop order would become a market order and the share would be sold, locking in earlier gains.

Find out more about when you should sell shares

The benefits and drawbacks

The advantages of a stop-loss order include not having to constantly monitor how your investments are performing during periods of volatility, which may be particularly beneficial if you have limited time available. This investment strategy enables investors to avoid selling shares too soon that might still produce profits by rising in value, and conversely stop them from holding onto shares that are falling in value for too long.

However, the disadvantages include that a stop-loss order may be triggered when the stock is experiencing a short-term fluctuation in its share price. For example, there may have been a management change or bad news around a particular sector or stock may have caused a temporary dip in its value, but over time its fortunes may change.

A stop-loss order could therefore mean that investors risk missing out on long-term profits from their investments, if they are unwilling to ride out the ups and downs of the market.

It’s important to remember that investments should ideally be held for at least five years, but preferably much longer. Remaining invested throughout market cycles means it’s less likely you’ll make badly-timed decisions, and you’ll also keep costs down by making fewer transactions. There are no guarantees however and staying the course doesn’t remove the risk that you could lose money in the end.

Learn more about buy-and-hold investing