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Stop loss orders are a helpful order type to have in your investing bag o’ tricks. But this order type comes with a dangerous flaw that could cause a nasty surprise when your trade is executed.
Below we’ll take a look at what stop loss orders are, how to use them to protect yourself from losses and, of course, the flaw we just mentioned.
What Is a Stop Loss Order?
A stop loss order is an order type where you set the specific price that you want to buy or sell a stock for. The price you set is known as the stop price.
There are two types, a sell stop loss and a buy stop loss.
If you place a buy stop order for a stock, that means you’ll buy the stock when the price climbs above your stop price. This is often used to close a short position on a stock.
More commonly, however, you’ll put in a sell stop order on a stock you own. That means that you’ll place a stop order at a price below the stock’s current price. If the stock drops below that stop price you set when you placed your order, your order will be executed.
I like examples. Do you like examples? Great! Here’s an example of how a sell stop order works…
You own shares of Dan’s Pooper Scooper Service (ticker symbol DGDO). DGDO is trading at $40 a share. You place a stop loss order at $30 a share. News gets out that Dan is actually a cat person and customers flee the company. Share price drops. If the price drop hits $30 a share or less, your stop loss order is executed and your shares are sold.
Why Use Them?
Stop loss orders are used mainly for protection. You would use a sell stop order to prevent losses in case the price of a stock tanks. Basically you use it to limit your losses (or potentially lock in gains) if the share price moves in the opposite direction than you’d like.
A Very Important Tidbit of Info About Stop Loss Orders
There’s an important little tidbit of information on stop loss orders I haven’t shared with you yet. I wasn’t holding out on you to be a dick. I just think now is the right time to share this info. So, here goes…
If you place a stop loss order, your order will be converted into a market order at the stop price or below.
Did you catch that?
The key part is “market order”. If you remember, a market order is an order type that immediately gets executed when it’s placed. However, it does NOT guarantee the price the order is executed at.
The Risks of Stop Loss Orders
Which brings us to the main risk of stop loss orders.
If a stock suddenly tanks, or gaps lower, below the stop price, your order will be triggered. And it may be triggered well below your stop loss level.
Let’s go back to DGDO. Imagine a situation where the stock closes one day at $30.01 a share and your stop loss is at $30 a share. After the market close is when the news hits about Dan’s secret life with cats.
The next day, the stock gaps down and opens at $24 a share. Because stop loss orders go into effect at your stop price or lower, your order gets executed at $24 a share. That’s 20% less than your stop loss. Ouch!
So basically, when you use a stop loss order, you give up control of the price you sell your stock at.
Oh, one other potential downside to stop loss orders.
When you enter a stop loss order, that order is public info. Which means slick Wall Street douchebags and their algorithms can play games with you and others who have a stop loss in place.
They do what’s called “run the stops”. That’s when they force the stock price low enough to trigger a bunch of stop loss orders. After the stock is sold at the popular stop level, the price will rally again.
Just something to be aware of.
Anyhoo, on the plus side, stop loss orders can limit your losses. Plus, it’s a guarantee you’ll unload the stock even if you can’t be guaranteed the price.
