The Simple Way A Stop-Loss Order Protects Your Investment - Modest Money
As an investor, the biggest risk you face is losing money. While the goal is to make money in the stock market, no matter how much research you put into a stock it doesn’t guarantee that you will see a positive return on your investment. If only there was a way to lower the risk of losing money. Well there is and it is called a stop-loss order.
Understand that a stop-loss order won’t eliminate the possibility of losing money, but it can help you to lessen the risk. The good news is that a stop-loss order is simple to set up and almost every broker will offer this option for you.
So let’s take a look at what a stop-loss order is and how it can start helping you to lower your investing risk.
At its most basic, a stop-loss order is an instruction you place with your broker to sell a stock in the event the price drops below a certain limit.
For example, let’s say you want to buy stock in XYZ company. It is currently trading at $75 per share and it is releasing it quarterly earnings in a few days. You think they are going to blow their estimates out of the water, but there is always the risk that other investors won’t be impressed and sell the stock.
You feel that a share price of $70 is what you don’t want to go below. So you place your stop-loss order with your broker. You buy 100 shares at $75 per share and place the stop-loss at $70.
Fast forward to their earnings release and the stop price pops to $80 per share. You have nothing to fear as you were only worried about a potential loss.
But let’s say the stock did drop to $65 per share. When the price hit $70, it would trigger your broker to sell your shares, protecting you from further loss.
So while you did lose money, you limited your loss by having a stop-loss order in place.
Other Ways To Use A Stop-Loss Order
While the example above was for a long position, you can also use a stop-loss order on a short position as well.
For example, let’s say you want to buy XYZ company stock if its price rises to above $50 per share. You would place your order with your broker and if the stock price rises to above your threshold, then you would buy XYZ stock.
Drawbacks To Stop-Loss Orders
While what I presented above looks great, there is a drawback of a stop-loss order. This drawback is if the stock suddenly trades at a large gap.
For example, let’s use the original example of XYZ stock. It is trading at $75 per share and you expect it to rise when they report earnings. You place your stop-loss order for $70 to protect any downside loss.
Fast forward and XYZ releases earnings after hours. They missed earnings and the next day, the stock opens trading at $60 per share. Since the share price is $60, your order will be placed. Unfortunately, the sell price of $60 is much lower than your stop-loss order of $70.
So while a stop-loss order does protect you most of the time by limiting your losses, there are situations where it won’t help you as you planned.
Finally, some brokers do charge a higher fee for you to place a stop-loss order. Make sure you understand the pricing structure of your broker and factor this into how you set up your stop-loss order so that you are only exposing yourself to a degree you are comfortable with.
At the end of the day, there are risks with investing in the stock market. You can limit some of this risk with a stop-loss order you place with your broker.
While this order won’t eliminate your risk of losing money 100% of the time, it will work most of the time to limit your losses to an amount you can live with.